Inflation: 'Picnics' Are a Shadow of Their Former Selves

MELBOURNE — It looks like the most anticipated interest rate move in modern central banking history will be a bit of a fizzer. I’m talking about tomorrow’s interest rate decision by the US Federal Reserve.

Overnight, US inflation data for the month of July revealed an absence of price pressures in the world’s largest economy. Core inflation (which strips out energy and food prices) rose 0.1% month on month in August and 1.8% for the year.

There was no change in the annual inflation rate from the prior month either, a sign of benign inflationary pressures. This suggests the Fed will probably wait another month or two…or longer, before finally biting the bullet and hiking rates.

Word from the Ministry of God supports this view. Lloyd Blankfein, head of Goldman Sachs and self-proclaimed doer of God’s work, reckons the low inflation data means the Fed should hold off raising rates.

That’s settled it then. The Word has come down from upon high.

The benign inflation data explains the jump in the gold price overnight and the rise in stocks across the board. There is less panic in the air. Faith in the Fed remains as it is now and as it shall be.

Or as long as inflation remains low, anyway.

The funny thing about inflation is that it’s a sham. If the Fed want to see a bit more inflation all they have to do is change the way it’s measured.

As anyone who shops regularly knows, the ‘new’ inflation occurs by way of lower quality and smaller sizes. Yesterday, I dropped into the local supermarket to get a few things for dinner. My girls (aged six and two) hadn’t had their sugar fix for a few days, and, fearing an ‘episode’, I got them some chocolate for dessert.

I grabbed a bag of ‘fun size’ picnics and of course sampled one as soon as I got home. Fun size? They are a shadow of their former selves. They’re pathetic little shrivelled up excuses for a kids treat.

But that’s how inflation manifests itself these days. It doesn’t occur through honest price rises. It takes place through product shrinkage and use of lower quality and cheaper products.

The drive to lower costs (or prevent prices rises) is all about improvements in technology and increases productivity. Or so we’re told. But lower prices are mostly a result of lower quality or product shrinkage. Much of it happens on the sly. It’s only recognisable after a time.

The statisticians recognise improvements in computing power as a deflationary force. And so they should. This is a genuine, technology led fall in prices. But if they recognise quality improvements they should also recognise quality deterioration.

When you get less bang for your buck, either via lower volumes or worse quality — that is inflation. It is a diminishment of your purchasing power. A signal from market forces that the fruits of your labour no long buy you and your family what it used to.

But don’t expect things to change anytime soon. The powers that be like things just the way they are. Low statistical inflation means low interest rates for longer. Which in turn means higher asset prices.

The powers that be would love for this benign environment to last forever. But nothing lasts forever. In nature, change is the only constant. Markets and economics are no different. The biggest question investors face right now is: when will the benign environment for asset prices change?

Are we simply going through a standard market correction before stocks resume their bull market? Or is this the start of a long-term bear market? Vern Gowdie has laid out the answer for you here.

Let’s have a look at what the stock market reckons. Below is a chart of the ASX 200. As you can see, the index is well off its highs. The trend of the market is now down. But it has found support around the 5,000 level, having bounced from that area three times now.

That doesn’t mean the market is at a bottom. It just means that for now, the 5,000 point level is an area where investors see decent value. When selling brings prices back down to these levels, buyers come in and provide support.

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After such a large fall, it’s natural for prices to consolidate for a few months. This is the market biding time while it decides what to do. Bears sell and bulls buy, shares change hands based on millions of individual beliefs and decisions.

At some point, stocks will move out of their consolidation range. Given the market is in a downtrend, there is a greater probability that prices will follow the path of least resistance and head lower.

But it’s not assured. It would only take the RBA to come out and cut rates a few times to fire the bulls up again and cause the bears to cover.

Right now, it looks like the RBA is happy to sit on its hands and do nothing. That may change if the economic data continues to worsen but with rates already at 2%, there’s not much left in the tank.

Given the dominance of the banks on the overall market, much depends on their earnings outlook. If they maintain their dividends and earnings hold up in the face of a slowing economy, then the market will remain supported.

But if they cut their dividends based on lower growth and having more shares on issue, then the bulls may lose conviction and send prices lower.

So keep an eye on the banks. If prices break below their recent lows, you’ll know the earnings outlook for the sector has worsened. And if the banks aren’t increasing their profits, then you’ll know the rest of the economy is stuffed too.

Regards,

Greg Canavan
for The Daily Reckoning, Australia

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