Inflation, Deflation, or Disinflationary?

One macro development that is showing visible divergences is the disconnect between the inflation/deflation indicator and inflation expectations. This is very important as this has major implications as to how to position financial assets across the world.

The inflation/deflation indicator is a ratio of a basket of inflation-sensitive stocks, including many mining and energy related stocks that tend to perform better the economy is strong against a basket deflation-sensitive stocks including banking, insurance, and utilities industry stocks that perform well when the economy is weak. The ratio tends to rise in strengthening or inflationary economic environment and tends to fall in a slowing or a deflationary economic environment.

Inflation expectations are what people expect future inflation to be. This is important because expectations tend to impact people’s behavior as it pertains to investing, consumption, spending, saving, etc. You can say how things in the past can influence what you do today. You can also say expectations about the future can also impact what you do today. Some of the key inflation expectations metrics are Reuters/Jefferies CRB Index (CRB), iShares TIPS Bond ETF (TIP), and Gold Commodity (GOLD).

A brief analysis of the inflation/deflation indicator chart is mixed. After a major bottom in Jan of 2016 (0.151), and a subsequent major technical bounce, it looked like the start of a sustainable recovery. However, this was not the case as the inflation/deflation indicator quickly transitioned toward a well-defined downtrend channel as defined by 0.1577 and 0.2256. Although the downtrend channel implies a bearish trend or deflationary, the ability to find support at 0.178 (2/13/20) or just above its 2019 pivotal lows (0.171-0.169) also hints of the potential for a near-term bottom. A daily golden cross buy signal as evidenced by the 50-day ma (0.19) crossed above its 200-day ma (0.18) during Dec 2019 is technically constructive. Nonetheless, the dominant trend for the inflation/deflation indicator is a downtrend. So, it would need to surge above its 2019 downtrend (0.20) and preferably above the top of its 2016 downtrend (0.2256) to confirm an intermediate term recovery.

Although the inflation/deflation indictor hints of the possibility of deflationary pressure we note the major disconnect between the indicator and inflation expectations. Interestingly, inflation expectations show a different picture. Commodity prices (CRB Index) may be under pressure but it appears a near-term bottom may be developing. Gold prices continue to trend higher and may be headed for a retest of its all-time highs. US Treasury Inflation-Protected Securities (TIPS) continue to set new all-time highs.

Talking about a major disconnect. How is this possible that the inflation/deflation indicator is pointing to a downturn (economic weakness) and inflation expectation indicators are stabilizing or trending higher? Interest rates have fallen strongly, while deflationary forces remain relatively weak. Consequently, this suggests real rates have risen leading to a rise in gold prices and possibly to the appreciation in TIPS security.

Is it possible that we are neither in an inflationary or deflationary environment? Rather, does this imply a disinflationary environment. An environment that is denoted by a long-term decline in the rate of inflation or a very low historical inflation rate that is also accompanied by a moderate economic expansion cycle. Although disinflation is a gentle form of deflation, disinflation isn’t necessarily bad for the stock market. Under this environment, stocks including growth stocks tend to perform relatively well if inflation remains accommodating and the economy does not slip into a contraction/recession.

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