Outward appearances suggest that inflation is not a problem (yet) rather it is deflation that is all the rage. However, beneath the scenes inflationary pressures and growth expectations are building rather rapidly. We do not think that analyzing “official inflation” statistics does one any good if you are trying to keep ahead of the market. In any case we are always highly suspect of official government statistics such as PPI and CPI because there is a tendency to understate true inflation. Why? Inflation targeting is now seen as the primary objective of many central banks. Accordingly it does not take a rocket scientist to work out that there is a vested interest to understate inflation. Anyway, we believe that the ultimate judge is the market. So we look at the market for signals about what is happening on the inflationary front. We essentially use five indicators:
- Emerging market small caps vs. developed market small caps (EWX vs. GWX)
- Commodities in general relative to gold (CRB vs. GLD)
- Non US inflation protected treasuries vs. ex US unprotected treasuries (WIP vs. BWX)
- Commodity stocks vs. the broad US stock market (CRX vs. VTI)
- Commodities vs. US 30 year treasuries (CRB vs. USB)
These relationships are depicted below. What constitutes a trend? We know from experience and research that something that outperforms on a rolling 6 month basis tends to keep outperforming. So we simply use the 6 month rate of change as an indicator of whether or not the trend is positive or negative.
Emerging market equities are highly sensitive to world growth and small caps tend move in observable trends more than large caps do. So we look at emerging market small caps vs. developed market small caps. This gives us an indication of world growth.
Contrary to popular belief there is only one world currency and that is not the USD. It has been (since more or less man began throwing spears) and will continue to be Gold. Paper currencies are just a modern thing (ever since the gold standard was abolished in the early 1970s). If a broad basket of commodities starts to advance relative to the world’s reserve currency (gold) then it also indicates world growth.
We could look at TIPs vs. the US 10 year but everyone looks at that so we opt to look at the “ex US” version of TIPs vs. 10 yr treasuries.
Relative performances within equity markets have a respectable record of anticipating things, specifically the performance of commodity stocks relative to the broad equity market has a respectable record of anticipating movements in commodity prices themselves (which indicate inflation or growth or some combination of the two).
Commodity prices outperforming long dated US treasuries have a respectable record of anticipating inflation.
The up trends above look reasonably robust with a series of higher highs and higher lows. We see these trends continuing over the coming months.
To
us the market is sending very strong signals that world growth and inflation is picking up. We are not above the market (and have seen very few cases of anyone who has consistently outperformed the market) that is why we follow it. Some of you may be wondering why we are mixing global growth and inflation together. Yes there is a fine line between pleasure and pain!
