Talk is Cheap

Apparently, inflation has returned. Also, the economy is teetering on the brink of recession. Also, Fred Thompson is going to be the next US President!

Only problem is, we haven't seen much real data to prove any of it.

Without question, it's been a tough week for markets. As of this writing, the S&P 500 is back to 1490, down about 1.8% for the day. Long bond yields have popped up too. 10-year US Treasury yields hit 5.12% and 30-year fixed-rate loans in the US are at 6.53% (according to Freddie Mac).

The supposed culprit of all this is the return of global inflation.

Years of Global Growth Raise Inflation Worries
By Marcus Walker, Greg Ip and Andrew Batson, The Wall Street Journal (*site requires registration)
https://online.wsj.com/article/SB118109624836326011.html?mod=todays_us_page_one

For years, economists told us global inflation remained low because cheap labor and production in Asia allows the west to acquire cheap goods without higher costs. In addition, Asia's plentiful cash balances consistently flow into US and Europe, propping up asset prices and keeping interest rates low.

The party has to end sometime, economists say, and now it looks as if the Asian juggernauts are finally going to withhold the punchbowl and derail our fragile economy. With global employment tight everywhere and operations at near full capacity, we'll see higher employee costs that stoke inflation and raise interest rates. All of this will cause Asian capital to stop its migration and stay home.

First, let's get some perspective. This week's sagging market doesn't constitute a huge change. The media is attributing what it believes to be a massive economic event to a relatively small market move. And let's not forget just four years ago the S&P 500 sat below 900. Today it's near 1500. But even in the context of year-to-date 2007, markets are still nicely positive. And anyway, this is minor volatility even by today's benign standards (the VIX index is still near all-time lows).

Relative to the aggregate earnings yield on stocks, long bond yields are still very low. Current aggregate data reveals contained, benign inflation around the world that could actually be decelerating. US core inflation is below 2.5%, inflation for the European Monetary Union is at or below 2%, and Japanese inflation is flat at best, if not slightly negative. (Conversely, the resurgence of Japanese deflation could be something to keep an eye on.)

We've written in this space often that global monetary policy has been spot on in recent years. Conventional wisdom says central bank interest rate changes require between twelve and eighteen months to take effect. If that's the case, then the tightening cycle initiated by the Fed and other major central banks a year and a half ago is clearly doing its job today, yes?

Economic fundamentals haven't changed either. All discernable economic signals, from OECD forecasts, to economic indicators and surveys, to Fed projections, to consensus economist forecasts, are pointing to a very strong second half of the year for the global economy. If anything, the so-called "slowdown" is already passed. (See our past commentary, "Good Data, Bad Information".)

Lastly, this business of an Asia-driven global economy doesn't hold water. It's simply a fantasy to think Asian liquidity and exported goods alone are fueling global markets. Yes, Asian borrowing is getting more expensive as rates tick up globally, but let's not over-blow things—we're still talking about relatively small interest rate moves on already extremely low borrowing rates. And net flows of foreign capital into the US are surging (see yesterday's commentary, "Mmm…Bacon" for more).

As for labor and capacity tightness, why not consider the unfathomable idea that corporations will respond by expanding operations! Why not a surge in capital expenditures? Besides, wasn't low wage growth supposed to sink the economy just a year ago anyway? Now higher wage growth will sink the economy? This is a joke, right?

We're in the midst of a period of solid economic growth, high liquidity, and low inflation. And the fundamentals haven't yet changed. Talk is cheap, but the facts haven't budged. Stay bullish.