Typically Fall does not follow Winter, but it can in terms of the Market’s Fundamental Gravity, as a significant rise in inflation appears on the horizon, says Landon Whaley.

In July 2018, all three primary gauges of U.S. inflation (consumer, core, and producer prices) had been accelerating for six to 24 months, depending on the indicator. Based on that trend, the Old Institution and its followers were calling for inflation to ramp higher for the remainder of 2018 and well into 2019. They simply looked at what inflation had been doing and extrapolated that trend forward.

In “The Playbook” on July 16, 2018, we said, “Despite everyone’s belief that inflation is pulling a Superman and going up, up, and away, inflation—along with growth—will begin to slow towards the end of 2018 and heading into 2019.”

Rather than use the highly scientific technique of straight-line extrapolation, we had evaluated U.S. inflation using our models, which consider factors like base effects and the non-periodicity of economic data sets. We realized that inflation was likely to peak and alerted clients accordingly. We were right, and the June-July 2018 period marked the cyclical high in all three primary inflation gauges.

On March 11, 2019, we made the call that “U.S. inflation is bottoming, will begin accelerating, and will exert its influence on U.S. asset classes in the months ahead.”

Right on cue, both consumer and producer price inflation accelerated for the first time in eight months.

We then nailed the pivot back to slowing inflation in “The Playbook” on May 27, citing that our models were indicating inflation was going to head south once again. We were right, as both consumer and producer price inflation have now slowed in two of the last four months.

Dating back to last year, we are three-for-three calling inflation’s trajectory, let’s see if we can keep the streak alive.

Processes, Not Points

Whether we are evaluating markets or economic data, it’s important to remember that cycle tops and bottoms are processes, not points. While consumer inflation (and producer prices) is not yet indicating signs of acceleration, the process of U.S. inflation breaking to the upside has absolutely begun.

Core U.S. inflation has now accelerated for four consecutive months, and as of September’s reading is sitting at a 10-year high. Underneath the hood, core goods CPI is at the highest level since July 2012, and core services CPI is at a 12-month high. Not only that, but the costs of the most critical necessities are all increasing together: Shelter, medical costs, health insurance, and food expenses.

Also flying in the face of the languishing pace of consumer inflation is the reality that the average price of consumer goods has now accelerated for the fifth consecutive six-month stretch of time.

The September ISM manufacturing and service surveys also confirmed an inflationary pick-up, showing that manufacturing prices have accelerated for three consecutive months, and service prices are at a 12-month high.

The final catalyst kickstarting the U.S. inflationary impulse is the comps. Beginning in November (and running through March 2020), the pace of inflation will be competing against the cycle low inflation readings from the end of 2018. In short, the year-over-year math makes it highly likely that consumer and producer prices will join core inflation and accelerate for the next three to six months. 

The Playbook

When inflation begins to accelerate, it's going to alter the playbook in two significant ways.

First, we’re going to tighten up our short book because, unlike Winter, a Fall Fundamental Gravity is a bit more nuanced and requires us to be stingy as heck with any short positions we carry.

The second significant alteration will be in our bullish Focus Markets. This time last year, the reward to risk was skewed heavily in our favor for utilities, REITs, Treasuries, and Gold. However, 12-months and 20% to 30% gains later, the best days for those four markets are likely behind them, not in front. We will continue to dance with these four Focus Markets until the FG shift out of Winter is official, but we’ll have a quick trigger finger on any weakness from here.

Once we begin our Focus Market rotation, we’ll evaluate bullish opportunities in energy stocks, crude oil, a broad-based commodity basket, specific industries within the tech space, and Treasury Inflation-Protected Securities (TIPS), to name just a few.

The Bottom Line and The Call

Ronald Reagan declared inflation to be “as violent as a mugger, as frightening as an armed robber and as deadly as a hitman.” I wouldn’t go that far, but I will say that despite being the red-headed stepchild of economic indicators, nailing the direction of inflation is crucial to being positioned for opportunities and avoiding massive drawdowns.

You can time stamp it, take a picture of it or a Snapchat it (if you’re into that kind of thing). We’re doing our best Babe Ruth impersonation and calling our shot; the U.S. is going to get an inflationary impulse that lasts for months and significantly changes the Playbook for U.S.-based assets. This economic shift is occurring while many investors, like The Economist, believe that inflation is dead.

Please click here and sign up to receive the latest edition our research reports as well as to participate in a four-week free trial of our research offering, which consists of two weekly reports: Gravitational Edge and The Weekender.