Choose your inflation carefully

Good morning. The 47 per cent plunge in Spirit Airlines shares yesterday, after US courts blocked its acquisition by JetBlue, was ugly. But not as ugly as the stock’s long-term chart. The discount airliner has bled nearly 90 per cent of its value in five years. It also happens to be among America’s most-hated airlines. For the privilege of not buying Spirit, JetBlue stock rose nearly 5 per cent yesterday. Email us: robert.armstrong@ft.com and ethan.wu@ft.com.

The inflation index you use matters

When you read in the financial press about “inflation”, more often than not that means the consumer price index, the best-known and most-timely measure. But when the Federal Reserve mentions “inflation”, it probably means the personal consumption expenditures price index, which it has explicitly targeted since 2000.

This technical distinction is well known but often forgotten, and occasionally matters quite a bit to markets. Now may be one of those times. As investors debate whether the Fed will cut interest rates at its next meeting in March, the “wedge” between CPI and PCE core inflation has been rising since July and now stands at 100 basis points (the wedge is CPI minus PCE, in year-over-year terms):

The gap is being caused by surprisingly benign PCE inflation, which, in principle, the Fed should care a lot about. On a six-month annualised basis, core PCE is at 2 per cent — right on target. Based on Friday’s deflationary producer price index (which feeds into PCE), analysts expect December PCE data to look cool when it comes out next week. This is something the central bank could conceivably act on in March. It even earned a mention in Fed governor Christopher Waller’s market-moving speech yesterday:

If [private sector] forecasts hold true, then core PCE inflation in December will remain close to 2 per cent, when measured on a three-month or six-month basis.

PCE inflation of 2 per cent is our goal, but that goal cannot be achieved for just a moment in time. It must be sustained at a level of 2 per cent. As I said earlier, based on economic activity and the cooling of the labour market, I am becoming more confident that we are within striking distance of achieving a sustainable level of 2 per cent PCE inflation. I think we are close, but I will need more information in the coming months confirming or (conceivably) challenging the notion that inflation is moving down sustainably towards our inflation goal.

In a note to clients on Friday, Matthew Luzzetti of Deutsche Bank argues that the relative weakness in core PCE adds to the case for imminent rate cuts. Since the Fed targets PCE inflation, a 100bp CPI-PCE wedge means that the PCE-implied real interest rate is some 100bp higher than that implied by CPI. That suggests a greater risk of overtightening, and a greater need to lower nominal rates sooner. Luzzetti writes:

For a Federal Reserve targeting PCE inflation, these forecasts for the real policy stance point to the potential need for earlier rate cuts to ensure that policy does not passively overtighten. For this reason, we noted in a recent piece that we saw rising risks that the Fed would have to cut rates earlier than our baseline of June. This week’s [CPI and PPI] data, and in particular the implications for the real fed funds rate over the coming months, have added to those risks.

Importantly, these cuts would be to maintain the stance of monetary policy in the face of falling inflation, not to loosen policy.

The wedge has divided Wall Street economists. Barclays on Friday moved its call for the Fed’s first rate cut to March from June, citing downside surprises in PCE inflation. Morgan Stanley has argued the other side, noting that the Fed will probably care more about the composition of inflation. That is to say, while overall core PCE inflation has slowed down nicely, much of that has been driven by goods deflation, and PCE services inflation looks less settled. March might be too soon for the Fed.

Omair Sharif of Inflation Insights shares the latter view. He points out several PCE services categories, including medical care and portfolio management, that have dragged PCE lower but are likely to reverse. Portfolio management inflation, in particular, tends to track US stocks, which rallied in November and December. “The Fed understands what’s driving the wedge,” he says. “Over the next month or two, the risk is that these items start contributing more positively, [pushing] the month-over-month core PCE rate higher and narrowing the wedge.”

We tend to think the Fed will wait past March, because labour market weakness is not yet forcing its hand. But either way, the point is that when the Fed is data-dependent, investors should mind what data they’re depending on. (Ethan Wu)

USA versus ROW, part II

Yesterday I wrote about the staggering outperformance of US stocks versus their global rivals over the past decade, and whether investors should make a bet on mean reversion, and tilt their exposure away from the US now.

I could have posed the question at the core of my piece more simply. The stick-with-the-US crowd, as represented by Goldman Sachs Wealth Management and echoed by many readers, argues that the current premium for US stocks is appropriate or even low. This is for the simple reason that the US enjoys unique strengths, such as natural resources, demographics, technological excellence and better-run corporations. The superior earnings growth and below-average risk these create should justify a US premium. 

A premium, sure. But the size of the premium matters immensely. Below, from Bloomberg, is the total return for the S&P 500 and some large rival markets over the past decade and the decade before that, in dollar terms (I have included the S&P equal-weighted index as a way to gesture at the issue of the outsized contribution of the Magnificent Seven big tech stocks to US returns).

In 2004-14, the US had all the economic and cultural advantages it has now. But the S&P’s returns in that decade were no better than those of the FTSE, and trailed both Europe and the emerging markets. Nothing about the US makes it an intrinsically superior returns-generating machine, because investment returns are always partly a function of the price paid. So, again: what is the right premium?

Perhaps comparing earnings multiples confuses the matter. Instead, think about growth rates. The simplest way to do this is with the Peg, or price/earnings to growth, ratio. Below are the current forward price/earnings ratios of the markets listed above (from Bloomberg again). Assume that the growth rate of earnings in the US over our planning horizon is 7 per cent (in line with the past 10 prosperous years). That gives the US a Peg ratio of 3.1. Assuming the same Peg for the other indices renders an implied earnings growth rate for each:

This is awfully simple stuff, and using different growth assumptions for the US changes the picture somewhat. But the point is clear: the premium on US stocks implies either a very large gap in future growth rates, or a very large premium for stability. Do not be hypnotised by US stock returns over the past 10 years. They tell you little. Whether the S&P is properly priced relative to the rest of the world is a matter of implied growth rates and implied volatility.

One good read

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