May 16, 2018

What Happens To the Markets When the Economy Rolls Over While Prices Rise?

(we'll soon find out)

The economy (GDP) appears to be rolling over… right as inflation is heating up.

GDP growth for 1Q18 clocked in around 2.3%. Under normal circumstances, this wouldn’t be particularly bad. However, in light of the fact that 4Q17 GDP growth was 2.6%, which itself was down from the growth rate of 3.2% in 3Q17, it quickly becomes evident that the US economy is now softening.

Unfortunately, this is ALSO occurring at a time when inflation is rising sharply. To whit:

The NY Fed’s UIG inflation metric shows inflation to be 3.1%

The Atlanta Fed’s Sticky Inflation metric shows inflation to be 2.5%

Even the “official” inflation metric, the Bureau of Labor Statistic’s CPI metric, shows inflation at 2.5%.

It is easy to shrug off these data points as being short-term spikes, however, we are already beginning to see signs of REAL inflation cropping up in the REAL economy.

As I’ve noted previously, inflation enters the financial system in stages.

The first stage involves a jump in prices paid by producers. This means that those firms responsible for manufacturing goods and services suddenly see a sharp spike in the cost of basic materials they use to build/ manufacture their finished goods.

That process began in early 2016 and accelerated throughout 2017 into this year. Indeed, the Producer Price Index has risen in 8 out of the last 9 months.

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A few months here and there is no big deal, but a persistent trend such as this means firms will soon have to raise the prices of the finished goods they are selling or risk seeing their profits drop.

We hit that point in March 2018: according to the National Federation of Independent Business (NFIB), a net percent of 25% of small business owners plan on raising prices, a 10-year high and up from just 2% in 2016.

The NFIB is straightforward in its assessment: “This should raise the overall average increase in average prices for the economy.” In plain terms, higher prices will soon be hitting the economy.

A weakening GDP and higher inflation… there is a word for this, it’s stagflation.

And it will become the DOMINANT trend in the coming months.

Best Regards.

Deo Talaverano.

Chief Market Strategist DHF.

George Town. Cayman Islands.