Inflation Monitor - December 2016 Change Is Coming For Better & Worse

Inflation Monitor Summary – Composite Ranking

The Inflation Monitor is a monthly report that tracks inflation trends. We do this by monitoring various economic indicators, asset prices, and goods and services. The purpose of the Inflation Monitor is to provide more clarity to the CPI number for the average investor.

We summarize the Inflation Monitor statistical data into the Inflation Monitor Equilibrium. This equilibrium summary was devised to help investors understand the impact of economic statistics and what areas of the economy are providing inflationary pressures and which are providing deflationary pressures.

The numbers on this summary are a rating score of the amount of inflation or deflation that exists in a segment of the economy. 10 is the highest score possible to indication high inflation. 1 is the lowest score indicating high amounts of deflation. The brown line indicates the average number of all 9 components of the economy.

Inflation Monitor – December 2016 – Introduction

We have a lot to cover this month in the Inflation Monitor – December 2016. This is the end of 2016. It is a time for reflection for the year past and for pontificating the future. We all know no one can predict the future. And so much is up in the air with the recent populous trend changes, let’s focus on last year.

Let’s start with the US presidential elections. Donald Trump will be our next president (#45) in the US. Some people are happy, and others are sad. Regardless, we have a huge potential shift in the US with the results of the presidential election finalized. The first thing to address is that Trump may or may not pursue the same policies he campaigned on. Every presidential candidate has their platform, but not all of the promises actually happen. Let’s put these in the wait and see category up for discussion after his first 100 days. He will have about 100 days to prove his worth and keep the positive (market-related) momentum going.

While I have seen a lot of positive signs since Trump was elected, the US is overdue for a recession. The S&P 500 had a string of 5 quarters in a row of declining earnings. Apparently, no one noticed. I would consider this a recession, but the markets did not. The markets are always right regardless of what I think. It will be interesting to see what happens once the “new president smell” wears off.

I talk a lot about inflation and deflation in the US and on global scale. There has been a noticeable shift in the past few years from economic expansion (i.e. globalization) to a contraction (i.e. protectionism). This was prior to Trump’s election and may have contributed in part to his popularity. It is clear that the people are fed up with the global elites and globalization (at the expense of the people our politicians claim to represent). It is not just here in the US, but also in Europe. The more recent Italian referendum, which could be a potential problem for the Italian banks, and the UK Brexit show that the citizens of other countries also have the same disdain for their political elites.

People are not happy with their governments selling them out for foreign trade deals which could cause further harm domestically. In the US inflation has been an aggregate of 50% since 1998 and yet our real median household income has not changed at all. In almost 20 years, real income in the US has not changed. This means that we are no wealthier today than we were 19 years ago. The problem is that this does not impact the wealthy, it impacts people on the margins. The poor and the shrinking middle class are affected the most.

The problem is that this does not impact the wealthy, it impacts people on the margins. The poor and the shrinking middle class are affected the most. If a family is just making ends meet and their health insurance costs rise 30%-40% or more as we will see in 2017. How will that affect their disposable income? Quite a bit.

I discussed this problem of our health care system and a potential solution in my last post, A Simple Solution to America’s Health Care Crisis. Since that post was purely data and politics, here are some facts that need to be addressed. The nationwide average increase for health insurance will be 9%. If you live in these states, you are above average: CT 25% increase, TN 62% increase, OK 42% increase. This is just the rates you would pay. The choices are another matter entirely.

Proponents of Obamacare (ACA) claimed there would be a lot of competition and choices. Well in addition to the huge increase in the cost of health insurance, many states also have fewer choices. Nationwide, there are 650 counties with only one insurance provider. In 2016 this number was 225. Personally, I don’t count one insurance provider as a “choice”. That is a monopoly. There is even a county in AZ that had no providers.

Yes, you read that correctly. One county had no providers of health insurance. So in case you are not up to speed, the IRS mandates that you are required to pay for health insurance. If you don’t have health insurance, then you will pay a tax penalty. I don’t think this is what our founding fathers had in mind when they used the word “freedom”.

In the past 6 years, insurance premiums rose 3x faster than the rate of inflation. Insurance deductibles have risen 10x faster than inflation. This is in relation to median income which is flat since 1998. Is there any wonder people are mad? Is there any wonder why populism is taking hold in the US and around the world? I’m not surprised. I’m actually surprised it took this long to appear.

If you read my post, you will understand that this system doesn’t work. You cannot charge people for “insurance” on daily costs. Insurance is for large unexpected expenditures, not for common events. Consider my example of having house insurance that covers changing new lightbulbs.

The fact is that the Obamacare law is a mess and made the situation worse in many ways. However, the inflation in health care costs is a real problem. There is no easy solution if you want innovation and progress in medical advancements. In the words of Alan Greenspan, “I don’t know how this is going to resolve, but there’s going to be a crisis.” Even Bill Clinton acknowledges the problem, “You’ve got this crazy system where all of a sudden, 25 million more people have health care, and then the people that are out there busting it – sometimes 60 hours a week – wind up with their premiums doubled and their coverage cut in half.“

Health care in the US is a big problem with the fastest acceleration to a tipping point. Social security is also a problem, but the end game can be pushed much further out, which most politicians tend to do.

Getting back to the inflation-deflation debate…

President-elect Trump needs to make good on some of his campaign promises rather quickly to keep the optimism going. If he does this by pursuing protectionism, thus reversing globalization, this will be inflationary for the US. Globalization is by nature deflationary, so the reverse of this is inflationary. While only a few may balk at the benefits of globalization, if we need inflation, this is one natural path to get it. Of course, this will also cause other problems, such as trade wars, higher domestic prices without equally higher wages, etc. If you are looking at trends, this is one you should keep a close eye on.

Lastly, If you are not aware of the pension crisis we are heading into, you should read up on it. Here is a story I saw recently about the Dallas Police and Fire pension plan. This pension plan allowed a lump sum withdrawal from the plan. In August the board proposed pension benefit cuts so the pensioners exercised their right to take a lump sum withdrawal. After 500 million was taken out, they sought to freeze future withdrawals or they would not have enough to support the plan. While I’m sure there is enough blame to pass around, this is not a unique situation. Public pensions around the country are in danger of not meeting their pension promises. This could be a blog post in itself, so I’ll only go as far to say that much of this problem has to do with low-interest rates. If the pension expects 7.5% and it only gets 3% returns, then the pension will be underfunded. If you have a public pension that you can take as a lump sum, then I highly suggest you consider that option. You can always create an annuitized income stream with the insurance company of your choice.

We have been in a deflationary cycle since I started this Inflation Monitor and I don’t see the trends immediately changing, however, a reverse in globalization would cause me to rethink my thesis.

If you want to send me your questions, you can email them here:

I hope you enjoy this month’s Inflation Monitor – December 2016.

Kirk Chisholm

Reference Pages:

Quotes of the Month

“Debt is future consumption brought forward. Once debt is incurred, consumption that might have happened in the future won’t happen, and it should come as absolutely no theoretical surprise that at a certain level of debt, growth and income begin to diminish. That is exactly what we are seeing in the real world, even if those who espouse the reigning economic paradigm (Keynesianism) are still in love with their beautiful theory.”

Charts of the Month

Interesting Inflation Charts

This chart a permanent part of this inflation monitor so that the importance of it is not missed. John Hussman put this chart in one of his weekly reports a while ago. If I could find the report, I would link to it. You should definitely read his weekly reports. It was a great report about how interest rates relate to the amount of money in circulation. The basic idea is that as rates climb higher, there is less money in circulation, and when rates are low as they are today, there can be an enormous amount of money in circulation without causing high inflation. This idea is a basic concept in economics, however, visually it provides a greater impact to how things really work.

Think of it this way, if hypothetically the US government can support a debt of $100 at a 5% rate of interest ($5 a year), then how much can the US support at 0.05%? $10,000 or a 100x increase. If rates are at zero, then the number becomes infinite. Now, what if interest rates are negative, why wouldn’t the US print an infinite amount of money?

Obviously, this is hypothetical, but it is important to understand this principal. Once you do, then this is the important part you don’t want to miss. Look at the slope of the curve in this chart. While you may be able to exponentially increase the supply of money without increasing your debt service, the hard part is when you try to increase rates. You will learn very quickly that the debt is unsustainable. If you want to see why interest rates will not rise quickly around the world, this is it. Once you have created $10,000 in debt you will have to reduce it by 99% to reach the 5% rate you had originally. What are the chances of this happening?

Interest Rate Sensitivity

I think this is one of the most important charts you will look at this month. Quite frankly you should know this inside and out if you have any money at all in bonds. I say this because we are at what could be the end of a historic bond bull market.

If you have money in bonds, you need to seriously reconsider your allocation strategies

Here is a great quote from Bill Gross from his latest monthly letter

I and others however, have for several years now, suggested that the primary problem lies with zero/negative interest rates; that not only do they fail to provide an “easing cushion” should recession come knocking at the door, but they destroy capitalism’s business models – those dependent on a yield curve spread or an interest rate that permits a legitimate return on saving, as opposed to an incentive for spending.
They also keep zombie corporations alive and inhibit Schumpeter’s “creative destruction” which many argue is the hallmark of capitalism. Capitalism, almost commonsensically, cannot function well at the zero bound or with a minus sign as a yield. $11 trillion of negative yielding bonds are not assets – they are liabilities.
Factor that, Ms. Yellen into your asset price objective. You and your contemporaries have flipped $11 trillion from the left side to the right side of the global balance sheet. In the process, you have deferred long-term pain for the benefit of short-term gain and the hopes that your ancient model renormalizes the economy over the next few years.
It likely will not. Japan is the petri dish example for the past 15 years. Other developed market economies since Lehman/2009 are experiencing a similar fungus.
— Bill Gross, “How I Found My Golf Game But Lost My Wife to a Titleist.”

I think Bill Gross’ description of the global problem we face is very accurate and a look into the future. In case you are not familiar with what is happening in Japan — Deflation.

The Fed owns 35% of all US Treasuries longer than a 5-year maturity. Could we possibly make it easier for our politicians to spend our money? We create US Treasuries, the Federal Reserve buys them, and our elected officials spend the funds.This is money being created and spent by our politicians for whatever they want, not what we want (unless you are a “friend” of theirs). What makes it worse is that the politicians are getting used to this type of incentive structure. It will be hard to break them of this habit. It is essentially free money for them to do what they please. Call me crazy, but I think these funds would be better spent by the taxpayers. At least with the taxpayers, there is a free market approach to the funds going where they are needed.

Leading Indicators

Dr. Copper

Dr. Copper is still weak, although there has been a strong bounce in the past few months.

Financials

Fed raised interest rates in December. The latest rate hike was 12 months later. The expectations are for 3 rate hikes next year. Well to put this Fed claim into context, last year they expected 4 rate hikes… We got one. This year they expect 3. Does this mean we will get 3/4 of a rate hike? I sometimes wonder if the Fed is roll dice or relying on tarot cards ( no offense to tarot card readers). The big question is, how is the financial sector going to make money when the spread is shrinking and rates continue to drop and go negative? How will insurance companies and pension funds survive? One more question… What happens when the US has negative interest rates, and that causes people to pull money out of the financial system. If banks create money (and they do via the banking process of lending), this causes inflation. What happens when money is pulled from the system, this could cause a huge amount of deflation to hit most markets. Keep that in the back of your mind if the Fed experiments with negative rates.

Right now the financial sector is having a good run. The spreads are increasing and the prospect of loosening financial regulations has caused their stock prices to rise. I’m not so sure this will happen, but we will know more when Trump starts showing his hand at what policies he wants to pursue.

Consumer Price Index (CPI)

Inflation is caused by excess demand. Historically this is caused by a fully-employed economy which also has a huge government spending program in place (which frequently happens in wars).

The CPI is flat for the year. It just started picking up again. If you have read this Inflation Monitor report for the last 12 months you will know that strong deflationary forces are here to stay. The Fed does not want deflation in the US, but can they stop it?

Producer Price Index (PPI)

The Producer Price Index is continuing to have a rough time this year. The declining PPI might be a reflection of the new economic conditions of producers and manufacturing with a high value of the US Dollar. This makes it harder for US companies to export goods since they will be about 20% more expensive from where they were last year.

US Velocity of Money M2

There is just no sign of stopping this falling safe. I’ll believe in the hyper-inflation tooth fairy when this starts to turn up in a meaningful way.

Monetary Base

Oil Prices

Rystad Energy just released an independent study that shows the US is considered to have more oil reserves than Saudi Arabia or Russia. This is the first time in history where the US has held this title. The study estimates the recoverable oil available in the U.S. at 264 billion barrels. Saudi Arabia has about 212 billion barrels and Russia has about 256 billion barrels.

“We keep thinking that lower energy prices are somehow good for the economy. That can’t be, because energy prices or commodity prices in general don’t drive economic growth. Economic growth drives commodity prices.”
~Stephen Schork

US Gas Prices

Currency Relative Valuations to Gold

Gold is priced in the currency you use every day. If you live in the European Union, you use Euros, if you live in Japan, you use Yen, and if you live in the US you use US dollars. Each of these currencies is used to buy gold in their respective countries, so we look at gold priced in each country to see how people value it in their own currency. This can tell us a lot about the demand for gold inside and outside the US.

Gold prices are they strong or weak?

The best way to look at any commodity, especially gold, is to compare the commodity to multiple currencies. If gold is rising or falling in US Dollars, that means nothing if the other currencies are not showing the same thing. A true bullish trend in gold is when gold is rising in all (or at least most currencies).

Gold is still in a bull trend.

Gold Priced in Euros

Gold Priced in Yen

Gold Priced in Canadian Dollars

Gold Priced in Australian Dollars

Bonds

TED Spread

A surge in the Ted Spread means a lack of trust in financial institutions. Currently, the Ted Spread is on the high side. It is far from the 2008 highs of 4.6, but the upward trend is not a good sign since it is confirming financial institutions are not trusting each other.

10 year vs. 2 year Treasury Spread

The flattening (or inverting) of the yield curve is not good for banks and also typically shows signs on a recession. It is probably one of the best indicators of a recession we have, yet no one knows the status of whether this indicator still works since interest rates are stuck close to zero. I don;t know what will happen if the US has negative interest rates? what will the curve look like then?

Treasury vs Corp Bond Spread

The spread between 30-year treasuries and corporate bonds is climbing, as it can be in times of market distress. It will be interesting to see how this plays out as interest rates start to rise.

High Yield Bonds (Junk Bonds)

High-yield bonds are a warning sign for the equity markets. They tend to track the equity markets well, but they can also be a warning sign for the bond market.

Bond Yield Spread

High Yield Bond Spread

The high yield bond market is continuing to cool down. This is a good sign for the overall market.

Asset Class Forecast

Inflation Dashboard

I like this view from the Federal Reserve because it gives more of a visual perspective of the data presented above.

Corporate Debt as a Percentage of Equity

Anything below 40 is when it is dangerous to own stocks.

Baltic Dry Index

After breaking below the index all-time lows late 2015, it hit a low in early 2016 and has rebounded since then. It could be the rise in oil prices, or just that the index can only go so low, where any increase in activity would push it up. The importance of this index is to show the health of global trade and international shipping. Improvement in this index is a positive sign

Charts I found interesting…

Financial institution failures over time

Billionaires by university

Clinton Decline

Most common jobs by state

Corporate Tax Rates by country

The earnings game

Change in earnings

earnings expectations over time

Earnings expectations

Earnings growth

Earthquakes

Changing forecasts

Presidential campaign spending

Energy consumption

Energy Prices

US energy production

Fastest internet

Facebook interaction by news media

Build up of Debt to GDP

Who benefits from globalization?

How does Congress spend your money?

High yield bond covenant restrictions

Cost of housing in US

Internet minute

China Smart Phones

US Decline in military experience

Overextending the shareholder friendly actions

Public Pension problems

Bloated Bureaucracy

Escape from work

Newspaper endorsements

Protectionism

Real Earnings of S&P 500

Are you open to a self-driving car?

Country sovereign credit ratings

Presidential impact on stocks

GDP growth and wages on country

Gambling on the US election odds

Reported crime by county

Venture Capital Deal Flow

How are your votes counted?

I hope you enjoyed this month’s Inflation Monitor. See you next month.

Cheers,

Kirk Chisholm

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Sources:

* IAG index calculations are based on publicly available information.

** IAG Price Composite indexes are based on publicly available information.

About Innovative Advisory Group: Innovative Advisory Group, LLC (IAG), an independent Registered Investment Advisory Firm, is bringing innovation to the wealth management industry by combining both traditional and alternative investments. IAG is unique in that we have an extensive understanding of the regulatory and financial considerations involved with self-directed IRAs and other retirement accounts. Innovative Advisory Group advises clients on traditional investments, such as stocks, bonds, and mutual funds, as well as advising clients on alternative investments. IAG has a value-oriented approach to investing, which integrates specialized investment experience with extensive resources.

For more information, you can visit: innovativewealth.com

About the author: Kirk Chisholm is a Wealth Manager and Principal at Innovative Advisory Group. His roles at IAG are co-chair of the Investment Committee and Head of the Traditional Investment Risk Management Group. His background and areas of focus are portfolio management and investment analysis in both the traditional and non-traditional investment markets. He received a BA degree in Economics from Trinity College in Hartford, CT.

Disclaimer: This article is intended solely for informational purposes only, and in no manner intended to solicit any product or service. The opinions in this article are exclusively of the author(s) and may or may not reflect all those who are employed, either directly or indirectly or affiliated with Innovative Advisory Group, LLC.