No inflation, no higher yields, buy stocks

Outlook:

Today’s calendar includes some good stuff, like the ADP private sector payrolls estimate. Thursday is better, with ISM, construction spending and vehicle sales. Friday, of course, is payrolls and factory orders (plus a speech by Fed Vice-Chair Fischer).

But no matter what the data says about the US economy, we have to worry about the Fed looking offshore for guidance on Oct vs. Dec, assuming we can believe the Yellen promise. Let’s say the US economy is healthy enough for a hike, which in the end is going to make very little difference anyway (except for enterprises already marginal). And let’s say the upcoming Chinese data is not too scary. But is the rest of the world ready for the psychological and symbolic effect?

We still have chatter about the ECB going deeper into QE. The FT reports “Even before the inflation data release earlier today, economists at Standard & Poor's said big risks from overseas (notably China) mean the central bank will likely pump up its bond-buying programme in size. ‘we believe the ECB will extend its QE program beyond September 2016, most likely until mid-2018, and that it could reach €2.4 trillion--more than twice the original €1.1 trillion commitment.’” Not everyone agrees, including RBC Capital. A single month’s reading will not suffice, and after all, core CPI is steady at 0.9%.

So, nobody knows what the ECB is thinking. For all we know, it is just biding its time until energy prices pick up. To some extent, Japan has the same problem, although with a more explicit acknowledgement that central banks can’t create inflation out of whole cloth. To say Abenomics has failed is not accurate, and to blame BoJ Gov Kuroda for sticking to the existing QE is to put the blame in the wrong place. Blame the frackers in the Dakotas.

We may be getting a respite from fear on the last day of the month and quarter, with everyone presumably having already done whatever positioning they needed to do, but it ain’t over yet. We just don’t know what the next trigger will be. Traders are primed to get fearful again. The FT has an interesting statistic—the VIX is up 47.3% over the quarter to 26.8.

At the close yesterday, the S&P 500 was down 8.5% year-to-date and down 11.7% from the record high of 2,134.72 from May 20. At the close yesterday, according to Market News, the German DAX was down 3.6% year-to-date and down 23.7% from the life-time high of 12,390.75 from April 10. Yesterday the Nikkei wiped out all of this year’s gains.

Maybe these levels are not enough to set your hair on fire and constitute a “crisis,” but they point to a lack of confidence in both economic growth and central bank leadership just about everywhere. Maybe folks are starting to get it that central banks really cannot manage whole economies with one feeble tool alone, as the central banks have been warning all along. It may be silly to say so now, but a little help from the fiscal side would not be amiss.

With Europe possibly falling back into deflation and Japan on the brink of a technical recession, not to mention at least some emerging markets in a serious pickle (Brazil), it’s hard to imagine risk aversion reversing into the embrace of risk anytime soon. This is a two-edged sword for the dollar. Safe-haven flows into the dollar may drag Treasury yields lower, which ends up being a dollar-negative. Fear over even the tiniest of hikes needing to be reversed and PDQ means the relative growth story (that favors the dollar) has even less traction than usual.

But here’s the good news: after stock markets express their dismay over central banks’ inability to create inflation, the idea will dawn that the only place to have any hope of a return is… the stock market. After all, if you can’t get yield from fixed income and real estate is too illiquid, that leaves equities, exactly as the bubble-theorists have been saying all along. Today we are all victims of the Japanese disease, even if other conditions are not Japanese (demographics, relations with China, etc.). The FT notes “The bond markets are not expecting outright deflation but are casting doubt on the Federal Reserve’s ability to hit its 2 per cent inflation target. Average inflation over the next 30 years priced into index-linked Treasuries has plunged to 1.6 per cent, the lowest aside from a few months around Lehman’s collapse.”

So, no inflation, no higher yields, buy stocks.

Is it even remotely possible a rising US stock market later on will pull the dollar up with it? Just a thought. Before then, get ready for a rout. Amid all the talk of earnings and historical P/E norms and the other factors that are supposed to drive stock markets, low inflation/low yield is still the one factor that counts the most. We will have one hell of a rally at some point, probably next year. At some point, central banks have to confess that energy prices are not just one aberrant and transitory factor but the central factor—but that’s a different story for another day.