A Glimpse into Structural Inflation. And Why QE is Nearly Inevitable.

October 20, 2024

With inflation sticking around, and global central banks priming the money pump, the stock market could become a refuge for investors as structural inflation becomes:                

STRUCTURAL INFLATION!

Global central banks continue to lower interest rates, and simultaneously increasing liquidity in the financial system. The markets are delivering a mixed response, while economies are flaccid.  Take the ECB’s latest 0.25 basis point cut, its third of the cycle bringing rates down from 4 to 3.25% and the response from the European markets as measured by the Vanguard FTSE Europe ETF (VGK), which amounted to a yawn. That’s because consumers are struggling and markets are betting on a drop in corporate earnings.  On the other hand, given the bullish looking ADI and OBV lines there may be some dip buying here.

You can also see investor hesitation in response to China’s less than full throated support of their economy via the notable absence of QE in the PBOC’s response repertoire to their shrinking economy.  In this case, it’s all about too many empty buildings, a loss of manufacturing capacity, and consumers who are struggling.  Yet, in both cases there may be some stealth money moving into FXI as the inevitability of QE appraoches.

In contrast, the U.S. stock market continues to rally, albeit in fits and starts, and at a slower pace than a few months ago since it’s come a long way as the Fed foreshadowed its own easing cycle. The difference is that the rate of inflation in the U.S. is rising faster than that of China or Europe. This suggests that inflation is what’s keeping the U.S. economy going.

I’m not sure that’s a good thing.  Still, investors have the upper hand, as quietly, the stock market is becoming a refuge against inflation and a significant cog in the economy.  Moreover, as interest rates continue to fall, and the eventual QE becomes the norm, more money is likely to flow into stocks.

Inflation is Becoming Irreversibly Structural and the Markets Smell QE.

The difference between the U.S., China, and the EU lies in their respective rates of inflation, which measure the rate of rise or decline in the present but ignore the inflation that’s already embedded in the system.  In other words, even if the rate of inflation is slowing, if you’re paying $1.25 in the present for something that cost $1 four years ago, real inflation is 25%. The longer prices stay elevated, even if they are no longer rising eventually takes its toll on consumers. Thus, if you’re paying $1.25 for something you paid $1 for a few years ago, you’re still paying 25% more even with an inflation rate of 0.

Both China and Europe are approaching flat inflation rates of based on their respective CPIs.  The former’s September print was 0.4% year over year while the latter recently sported a 1.7% year over year mark.  In comparison, the U.S. CPI grew at a 2.4% year over year rate in September.  But, if consumers are still paying more now than they were four years ago without commensurate increases in wages, then the rate of inflation is meaningless.

You can see this in the U.S. housing market, where a home which sold for $350,000 in 2020 is now on the market for $450,000, a nearly 30% price jump that’s not showing signs of receding rapidly even as home prices have fallen over the last six months.  Food costs are also remaining stubbornly high.  Just recently, I paid $7.99 for the same bag of avocados that were $5.99 two months earlier (34% inflation).  The upshot is that the longer this type of price level sticks around, the harder will be the squeeze on middle and lower level consumers. 

Let me flesh this out a bit a bit further.  When my father bought our first home in 1976, he paid 45,000 for it.  A recent Zillow search for the same house has it valued at $265,000.  It seems to still be in good shape.  But it’s the same house, which is now nearly 50 years older.  That’s a 489% price gain (10.2%) rate per year. 

What it all boils down to is that in the U.S.  inflation is now structural, and has in some ways been so for some time.  Meanwhile in Europe and China, inflation’s rate of growth is starting to flatten out, thus the situation is still in flux – structural at a lower level?  For the U.S. that means that the inflationary gains since 2020, some 20% by some accounts are becoming part of daily life and aren’t going away anytime soon unless something changes.  Yet a closer look, especially at housing inflation, suggests it’s been quietly becoming so for quite a while.

The take away is that in Europe and China consumers are starting to feel the pain of inflation to a larger degree than the U.S. where, via Pareto’s Rule - the 80/20 principle, the upper income consumer is still holding the economy up by paying up for goods which cost more than they once did.

The only solution in a debt riddled world where the European and Chinese economies are on the brink while the U.S. depends on the wealthy to hold things up is QE.  What could possibly go wrong?

U.S. Ten Year Note Remains Above 4%. 

The U.S. Ten Year Note Yield (TNX) has a new floor 4%, which is now becoming a stubborn support level. What could be worse would be a move above 4.2%, which is plausible as a response to inflation.

Mortgage rates have bottomed out. The real question is whether homebuyers on the fence will panic and take current terms as they fear of higher rates in the future.  Get the details on this topic here.  If you’re not getting my FREE weekly real estate and interest rate updates, you can sign up here.

Homebuilders Are Benefitting from Inflation REITs Search for Support.

Gold and silver are rising of late. But the homebuilder sector remains resilient, albeit while becoming more interest rate sensitive than over the past few months.  A reason for the steadiness in the sector is that housing and real estate ownership are still sound inflationary hedges.

The iShares U.S. Homebuilding ETF (ITB) just made a new high, delivering the big move I predicted last week based on the tightening of the Bollinger Bands around prices.  The 50-day moving average has been an excellent place to buy dips in ITB since it turned around in July.

The iShares U.S. Real Estate ETF is still testing its 50-day moving average.  This sector has been more sensitive to interest rates than the homebuilders.  Thus, much of what happens here will depend on what happens in the bond market.

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AD Line Flexes its Muscles

The New York Stock Exchange Advance Decline line (NYAD) is once again making new highs, following on the recent highs by the S&P 500 (SPX) with a new high on NYAD.

The Nasdaq 100 Index (NDX) is still setting up for a move above the 19,500-20,000 trading range, with 20,750 remaining an important resistance level.

The S&P 500 (SPX) made new highs last week and remains within reach of further new highs.  The 20-day moving average continues to be a viable re-entry level.

VIX is on the Downslope

The CBOE Volatility Index (VIX), is back below 20. A sustained move below 20 would be a positive.

VIX rises when traders buy large volumes of put options.  Rising put option volume leads market makers to sell stock index futures to hedge their risk and leads markets lower.  A fall in VIX is bullish signaling lower put option volume, eventually leads to call buying which is bullish as it causes market makers to buy stock index futures raising the odds of higher stock prices.

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Joe Duarte is a former money manager, an active trader and a widely recognized independent stock market analyst since 1987. He is author of eight investment books, including the best selling Trading Options for Dummies, rated a TOP Options Book for 2018 by Benzinga.com - now in its third edition, The Everything Investing in your 20s and 30s and six other trading books.

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