Rolling 5-Year Inflation
Instead of using the monthly inflation print, a 5-year (60-month) SMA is used to chart US inflation.
The SMA is used to cut back on noise from “transitory” inflation, giving a better view of the broader inflation environment realized over the past half-decade. Said differently, it illustrates the inflation environment which policymakers and central bankers are/were “dealing with.”
For a more short-term-oriented view of regime change, an EMA might be used in place of an SMA. A shorter-term view is likely to be more useful in the context of near-term interest rate cuts.
Historically, inflation tends to evolve from one “regime” to another. The implications of a regime change are enormous, and I am growing in my conviction that we are now in a new regime, as evidenced by the SMA breaking through a key level (explained below).
Since inflation prints (or, any macro data, for that matter) are a fool’s game to predict with a high degree of precision, I used a pseudoscientific approach which yielded 3.25% as the key level for inflation to “break through” to a new regime. Using 3.25% also gives us a “round” number, making it easier to quickly put inflation prints in context (for me, at least).
My commentary and some ideas to consider:
Why 3.25% is important: it had not been “breached” since 1996.
Put another way: the prevailing inflation environment has reached a level not seen in 28 years.
Why is 1996 important? A look back over the past century provides hindsight of when prior inflation regimes began and ended. After the “1970’s” (colloquially), we entered a new era which realized a prolonged downtrend in inflation worldwide. 1996 became a clear demarcation point upon identifying waves of “lower highs and lower lows” in the years since. Further, 1996 roughly coincides with the end of a series of markedly higher “waves” of inflation.
I feel it is relevant to also point out the dramatic changes in the world since we last saw 3.25% in 1996.
1. Internet
In 1996, the internet as we know it today was in its infancy. This is obviously a change of biblical proportions in the way we live, and never before in human history has the entire world been connected in this manner (i.e., we are the guinea pigs of computing). Entire libraries could be filled with commentary on the internet’s impact on the economy, so I will defer to the experts for opinions. That said, it has generally been disinflationary.
2. Tech Giants
Today, the 6 highest weighted S&P 500 stocks account for ~25% of the index. In 1996, of these six, only MSFT and AAPL were “established” companies, and even then, AAPL was in the midst of an identity crisis and was nowhere near the trillion dollar behemoth it is today. As for the remaining four: NVDA was founded three years prior in 1993, and in 1996 laid off ~1/2 of its then-100 employees. GOOG was still a research project of a pair of PhD’s and wouldn’t launch for another two years. AMZN was still in its first year of operations as an online bookstore, a far cry from its monstrous scale today. And, finally, the founder and brainchild of META, Mark Zuckerberg, was 11 years old, and the term social media was still about a decade away from entering even the fringes of society’s lexicon.
This is all to say, nearly 1/4 of the proxy for the “equity market” - the S&P 500 - is driven by ENTIRELY NEW “inventions” (or products, services, goods, etc.). In the context of inflation, NONE of these “inventions” have EVER existed in an economy with inflation “above 3.25%.” There is a mammoth amount of capital that is put towards tracking the S&P 500, and in order to balance weights when tracking, it involves the buying and selling of all its constituents together. Having been untested in a transition to a “higher” inflation regime, it remains to be seen how the heavyweights of the S&P will hold up. Should they demonstrate an inability to “absorb” inflation, it would likely result in a broader sell off of the S&P, and would be exacerbated by a rotation to fixed income should interest rates remain elevated and offer yield which is more attractive than uncertainty as to when the “absorption” will occur, if it does at all.
3. China
In 1996, China was still in its second stage of economic reforms, privatizing SOE’s, and would not enter the WTO for another five years. The consequences of China’s reforms have been enormous, and are potentially the most important influencer of inflation over the past thirty or so years. Again, this is another topic that could fill a library, and I will not elaborate more. That said, the effects of China’s reforms have been largely disinflationary. It is uncertain whether this trend will continue, as China is now facing a host of serious financial issues which could reach a boiling point. In particular, China is now the dominant player in commodity markets, virtually controlling the supply and/or demand for many of the world’s raw materials. How this interacts with China’s navigation of financial issues is uncertain, but has potential to be highly disruptive to global supply chains, which would push inflation higher.
4. Government Debt
The US’ prolonged wars in Afghanistan and Iraq, on which the country spent several trillion dollars over nearly two decades, were still several years from occurring. Unlike other wars in the 20th Century and in recent history, these wars were largely financed through government debt. In the opinion of many, these wars were considered to be failures. Largely agreeing with this notion, the expansion of deficit spending to finance “lost” wars not only diverted monies from useful purposes such as infrastructure and education, but also hastened the government’s need to “inflate away” its debt. According to a paper by Brown University’s Watson Institute, the interest expense alone on the debt used to finance these wars will likely exceed $2 TN by 2030. To put this in perspective, when considering the 2022 federal outlay for highway spending amounted to $47 BN, these interest payments on war debt are roughly equal to FIFTY YEARS worth of federal highway spending.
To make matters worse, the debt from the US’ wars pales in comparison to the bonanza in government spending in response to COVID. A whopping $5 TN in stimulus was doled out in a matter of months. It will take years to determine the ultimate effect the stimulus money will have had on the economy’s “intangibles”. For now, it is clear this spending spree has bloated the government’s debt, and input can be argued the US is running a dangerously high Debt/GDP ratio - a bellwether of inflation.
How does the government plan to dig itself out of this hole? Logic points towards the path of least resistance, which in this case means “inflating away the debt.” We very well may have already begun to see this process set in motion.
Inflation, by its nature, carries political implications, which has often led to charged discourse and sensationalized media headlines. This rings particularly true in election years (this year) and in times of collective struggle (the COVID era). Unfortunately, this can muddy the waters when trying to make sense of the data prints. My aim was to make a simple illustration which can uncover a regime change in inflation. It is up to the user to determine whether the regime change signal holds validity.
The SMA is used to cut back on noise from “transitory” inflation, giving a better view of the broader inflation environment realized over the past half-decade. Said differently, it illustrates the inflation environment which policymakers and central bankers are/were “dealing with.”
For a more short-term-oriented view of regime change, an EMA might be used in place of an SMA. A shorter-term view is likely to be more useful in the context of near-term interest rate cuts.
Historically, inflation tends to evolve from one “regime” to another. The implications of a regime change are enormous, and I am growing in my conviction that we are now in a new regime, as evidenced by the SMA breaking through a key level (explained below).
Since inflation prints (or, any macro data, for that matter) are a fool’s game to predict with a high degree of precision, I used a pseudoscientific approach which yielded 3.25% as the key level for inflation to “break through” to a new regime. Using 3.25% also gives us a “round” number, making it easier to quickly put inflation prints in context (for me, at least).
My commentary and some ideas to consider:
Why 3.25% is important: it had not been “breached” since 1996.
Put another way: the prevailing inflation environment has reached a level not seen in 28 years.
Why is 1996 important? A look back over the past century provides hindsight of when prior inflation regimes began and ended. After the “1970’s” (colloquially), we entered a new era which realized a prolonged downtrend in inflation worldwide. 1996 became a clear demarcation point upon identifying waves of “lower highs and lower lows” in the years since. Further, 1996 roughly coincides with the end of a series of markedly higher “waves” of inflation.
I feel it is relevant to also point out the dramatic changes in the world since we last saw 3.25% in 1996.
1. Internet
In 1996, the internet as we know it today was in its infancy. This is obviously a change of biblical proportions in the way we live, and never before in human history has the entire world been connected in this manner (i.e., we are the guinea pigs of computing). Entire libraries could be filled with commentary on the internet’s impact on the economy, so I will defer to the experts for opinions. That said, it has generally been disinflationary.
2. Tech Giants
Today, the 6 highest weighted S&P 500 stocks account for ~25% of the index. In 1996, of these six, only MSFT and AAPL were “established” companies, and even then, AAPL was in the midst of an identity crisis and was nowhere near the trillion dollar behemoth it is today. As for the remaining four: NVDA was founded three years prior in 1993, and in 1996 laid off ~1/2 of its then-100 employees. GOOG was still a research project of a pair of PhD’s and wouldn’t launch for another two years. AMZN was still in its first year of operations as an online bookstore, a far cry from its monstrous scale today. And, finally, the founder and brainchild of META, Mark Zuckerberg, was 11 years old, and the term social media was still about a decade away from entering even the fringes of society’s lexicon.
This is all to say, nearly 1/4 of the proxy for the “equity market” - the S&P 500 - is driven by ENTIRELY NEW “inventions” (or products, services, goods, etc.). In the context of inflation, NONE of these “inventions” have EVER existed in an economy with inflation “above 3.25%.” There is a mammoth amount of capital that is put towards tracking the S&P 500, and in order to balance weights when tracking, it involves the buying and selling of all its constituents together. Having been untested in a transition to a “higher” inflation regime, it remains to be seen how the heavyweights of the S&P will hold up. Should they demonstrate an inability to “absorb” inflation, it would likely result in a broader sell off of the S&P, and would be exacerbated by a rotation to fixed income should interest rates remain elevated and offer yield which is more attractive than uncertainty as to when the “absorption” will occur, if it does at all.
3. China
In 1996, China was still in its second stage of economic reforms, privatizing SOE’s, and would not enter the WTO for another five years. The consequences of China’s reforms have been enormous, and are potentially the most important influencer of inflation over the past thirty or so years. Again, this is another topic that could fill a library, and I will not elaborate more. That said, the effects of China’s reforms have been largely disinflationary. It is uncertain whether this trend will continue, as China is now facing a host of serious financial issues which could reach a boiling point. In particular, China is now the dominant player in commodity markets, virtually controlling the supply and/or demand for many of the world’s raw materials. How this interacts with China’s navigation of financial issues is uncertain, but has potential to be highly disruptive to global supply chains, which would push inflation higher.
4. Government Debt
The US’ prolonged wars in Afghanistan and Iraq, on which the country spent several trillion dollars over nearly two decades, were still several years from occurring. Unlike other wars in the 20th Century and in recent history, these wars were largely financed through government debt. In the opinion of many, these wars were considered to be failures. Largely agreeing with this notion, the expansion of deficit spending to finance “lost” wars not only diverted monies from useful purposes such as infrastructure and education, but also hastened the government’s need to “inflate away” its debt. According to a paper by Brown University’s Watson Institute, the interest expense alone on the debt used to finance these wars will likely exceed $2 TN by 2030. To put this in perspective, when considering the 2022 federal outlay for highway spending amounted to $47 BN, these interest payments on war debt are roughly equal to FIFTY YEARS worth of federal highway spending.
To make matters worse, the debt from the US’ wars pales in comparison to the bonanza in government spending in response to COVID. A whopping $5 TN in stimulus was doled out in a matter of months. It will take years to determine the ultimate effect the stimulus money will have had on the economy’s “intangibles”. For now, it is clear this spending spree has bloated the government’s debt, and input can be argued the US is running a dangerously high Debt/GDP ratio - a bellwether of inflation.
How does the government plan to dig itself out of this hole? Logic points towards the path of least resistance, which in this case means “inflating away the debt.” We very well may have already begun to see this process set in motion.
Inflation, by its nature, carries political implications, which has often led to charged discourse and sensationalized media headlines. This rings particularly true in election years (this year) and in times of collective struggle (the COVID era). Unfortunately, this can muddy the waters when trying to make sense of the data prints. My aim was to make a simple illustration which can uncover a regime change in inflation. It is up to the user to determine whether the regime change signal holds validity.
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