Inflationary Fears Could Soon Return

Inflation is back in the headlines... Why inflationary fears could soon return... Singer warns of a 'deep underlying complacency' in the markets... Europe is quietly growing again... New lows for the market's 'fear gauge'... Don't bet on higher volatility just yet...

Yesterday, a Wall Street Journal report highlighted what regular Digest readers have known for months...

Inflation is quietly ticking higher across most of the world's major economies. From the report...

After years of fighting against deflation, the U.S., the eurozone and Japan show glimmerings of life in consumer prices and wages, evidence that an era of exceptionally low inflation is receding from the global economic landscape...

"There are inflationary mechanisms rather than disinflationary mechanisms or deflationary mechanisms in place now," said Ian Shepherdson, chief economist at research firm Pantheon Macroeconomics. He pointed to stabilized global energy prices, rising prices for factory goods coming out of China, and a low U.S. unemployment rate set to drive an acceleration in wage growth.

The Journal also noted that recent events could make central banks – particularly those in Europe and Japan – reluctant to raise rates or withdraw stimulus too quickly. More from the Journal...

Though inflation is now practically at the ECB's target rate of around 2%, the central bank has shown no sign of paring its stimulus...

The ECB has a recent history of raising interest rates prematurely as inflation picks up. In both 2008 and 2011, the central bank began to increase rates, only months before reversing its policies and cutting rates once again.

It's a similar story in Japan, whose economy has fallen in and out of deflation for years. Even here in the U.S., Federal Reserve officials still reference their belief that the Great Depression of the 1930s was prolonged by tightening monetary policy too soon.

In other words, after years of battling deflation with unprecedented stimulus, central banks could be unwilling to react to inflation until it's clearly moving higher again... And by then, it could quickly get out of hand.

We're not alone in this concern...

Billionaire investor Paul Singer – whose Elliott Management hedge fund earned 14% annual returns for a remarkable 35 straight years – is also concerned about the risks of higher inflation. From Elliott's latest letter to investors this week (emphasis added)...

There is a deep underlying complacency which we think permeates global financial markets. The basically-low volatility of the last eight years has led to a widespread assumption that financial market volatility has been bottled and will remain controlled.

Moreover, despite the radical monetary policy which has become orthodoxy for the entire developed world's central banks, there is no fear of a near-term eruption of significant systemic price inflation. It is a fool's errand to predict the near-term course of inflation (and global central bankers and policymakers have failed miserably and continuously in performing this errand), but we believe that the global confidence in the placidity and boundaries of inflation (and global financial risk) is misplaced and overdone...

It will be interesting to watch. If inflationary expectations get rolling, it might be amazing how quickly they take hold. "Very quickly" would be in rough alignment with the magnitude of the monetary extremism of the post-GFC period, but there is no way to predict exactly how it will all play out.

This is one more reason we continue to recommend gold and silver...

This environment would be incredibly bullish for precious metals. And of course, it would be incredibly bearish for bonds...

This is because longer-term interest rates tend to rise with inflation, as investors demand higher yields to compensate for the loss of purchasing power. (Remember, bond prices fall as interest rates rise.) And today, bond investors are more exposed to the risks of higher interest rates than at virtually any time in history. If inflation begins to rise significantly, bonds will plummet.

Stocks will likely do well, too... at least for a while. As we've discussed, history suggests rising inflation should be bullish for equities initially. But as long-term rates pass a "tipping point" – approximately 5%, according to JPMorgan Asset Management – higher yields can begin to act as a "magnet" that draws money out of stocks.

In the meantime, more signs point to expansion in Europe...

This morning, global informatics firm IHS Markit reported its manufacturing Purchasing Managers Index ("PMI") for the eurozone rose to 55.2 (a measure above 50 indicates a sector is growing). This is the highest level in nearly six years.

The data were confirmed by reports of similar manufacturing growth in individual eurozone countries, including Germany, France, and even Italy.

This is another strong sign that Europe's battle with deflation is ending... and the recent pickup in inflation is real.

This is great news for Steve Sjuggerud's True Wealth Systems subscribers...

As regular Digest readers know, Steve turned bullish on European stocks last month.

He noted they met his three favorite investment criteria (cheap, hated, and in an uptrend), and had just entered "buy mode" according to his True Wealth Systems computers.

Perhaps most important, he noted European stocks had dramatically underperformed U.S. stocks over the past several years. This means there's plenty of room for them to play "catch up" if Europe simply moves from "bad" to "less bad."

Today's data suggest this trend could already be underway.

Finally, here in the U.S., we note stock market volatility has fallen back to multiyear lows...

The CBOE Volatility Index (VIX) – the market's so-called "fear gauge" – fell to an intraday low of just 9.97. Investors haven't been this complacent in nearly 10 years, since early 2007...

As you can see in the chart above, if there's one certainty in the markets it's this: Periods of market calm and complacency (when the VIX falls into the teens or lower) are always followed by periods of volatility and fear (when it leaps past 20).

But while we expect volatility to rise in the coming months, history suggests the recent lows in the VIX are actually sending a different message... at least in the short term. Our colleague Ben Morris explained this unusual situation in Monday's issue of his DailyWealth Trader service...

Folks are used to seeing the VIX rise when stocks are falling... and fall when stocks are rising. The VIX can rise along with stocks. But that's not the norm.

And when folks look at a chart of the VIX, they see low readings followed by high readings. So they conclude that an extremely low VIX means that it's about to jump higher... and that stocks are about to fall off of a cliff.

As Ben noted, this reasoning is logical. But it's not what the numbers show...

Over the past 20 years, the VIX has closed below 11 just 93 times, or 1.8% of all trading days. Over the course of the month following a close below 11, the benchmark S&P 500 Index never "fell off of a cliff." In fact, the worst decline within a month was negative 5.9%. (The worst decline within a given period is called a "drawdown.")

If a drawdown of 5.9% in a month sounds bad, consider that the average one-month drawdown for the S&P 500 (over the past 20 years) is 3%. So the worst one-month drawdown after the VIX closes below 11 isn't even twice as bad as the average for all one-month periods.

The average drawdown after the VIX closes below 11 was just 1.3%... or less than half the average for all one-month periods.

To be clear, this doesn't mean stocks are certain to soar, either...

History shows stocks also tend to rise less than normal after the VIX hits low levels. But Ben says this signal can still be useful for traders and investors alike...

First, it can help you stick to your stops and let your winners ride. That's extremely important to successful trading. Second, it can give you peace of mind, which allows you to go about your trading and investing as usual...

If you find a great buy, go ahead and buy. The whole "I'm going to wait for the market to pull back before buying" argument doesn't hold up. On the other side, the low VIX is not a good reason to load up on short positions, or other bets that the market will drop, like lots of traders think.

In sum, a low "fear gauge" is nothing to fear. The VIX is low... And that means the market isn't likely to be as volatile as normal in the coming month. Nothing more, nothing less. Trade accordingly.

New 52-week highs (as of 1/31/17): First Trust Nasdaq Cybersecurity Fund (CIBR) and CommScope (COMM).

In today's mailbag, several subscribers respond to Steve Sjuggerud's warning about brokers and exchange-traded funds ("ETFs"). Send your questions, comments, and concerns to feedback@stansberryresearch.com.

"Thank God for Stansberry products and advice. For someone to imply that recommending an ETF could be so risky as to infer that the person recommending it is not qualified is insulting... I strongly agree with Steve that it is time for a new broker. Surprisingly, many of the 'discount' brokers are very happy to carry out your wishes, and even at a discount.

"So yes, listen to Steve and the 'Stansberry Gang' and get out of Dodge. Enjoy your new experience with a different broker. If you want to stay with one of the big boys, then you still need to change your broker, who has proven they cannot be trusted to put your interests first." – Paid-up subscriber Mitchell F.

"What's up guys – Many larger brokerage firms are making it extremely difficult if not impossible to buy certain ETFs – they are currently blaming it on 'regulators' and 'policy.' Many accounts (including advisory or fee based accounts) are not allowed to hold levered or inverse ETFs at all and need to be held in straight commissioned accounts.

"Think on that one for a minute – firms are pushing for fee-based accounts due to DOL, yet policy won't allow you to buy certain securities (inverse no less). For those accounts which can hold such securities, they are restricted to less than 10% of what the client holds at the firm.

"I've been with you guys for years [as an] Alliance member... Many brokers shouldn't be trusted – though, as I've written to you before (before you came up with [Stansberry Asset Management, as that's basically what I do... your research is the best available on Wall Street, period), there are some who care about investors, who promote you, promote trade stops, promote discipline, promote quality investing... I have been fighting internally for years now, but never so much as I have these past 4/5 months..." – Paid-up subscriber M.K.

"I tried to buy [a similar ETF] today in my Merrill edge acct, which is linked to my main account with substantial assets and was told it was 'blocked.' I called and got the due diligence rap, but I could sign a 'do no harm' letter and state that I had a net worth in excess of $10 million... all for a $14,000 trade." – Paid-up subscriber A.T.

"I was a Registered Representative (Rep) of a Broker/Dealer (BD) for nearly 30 years. I had a very successful career, earning a substantial portion of my income from selling investments in addition to insurance and annuities. My initial contract with a huge mutual insurance company ended, and it resulted in a lawsuit, which according to the terms and conditions of the settlement, I cannot disclose.

"During an annual compliance interview with my next BD, I had enough, I excused myself from the interview, quickly typed a resignation letter and told the Compliance Officer to get the **** out of my office. I quit, gave up my revenues and quit. I subsequently signed up as an Alliance member, and have never regretted either decision.

"Here's how Reps are manipulated like the one your reader mentioned. If a Rep desires to sell an investment outside of the offerings of their BD, generally, a written request must be sent to their BD, which is usually denied and if they sell an investment because it is in the best interest of the client, whether they are paid or not, they are guilty until proven innocent of the act of 'selling away,' which is grounds for sanctions, fines, and termination. BDs make deals with funds to offer their products through their salesforce, many of which are considered captive and only sell products from their company and their BD. This practice is commonplace, it's how the distribution system works and how BDs generate significant revenues to support their enterprise.

"With the recently announced Fiduciary Rule, BDs are doubling down on Reps, either they sell what they are told to sell or their clients are no longer their clients, they are on their own. The Rep is using a client's trust in them to sell products that provide maximum revenues to their BD. Sadly, Reps are cornered, have a mortgage, kids in college, still paying student loans, and making payments on credit card balances like many and can't survive on less income. They are trapped by the trappings of their own choices. Because clients do not understand the markets, they must trust their Reps and their Reps recite the BD mantra, the 'newsletter writer doesn't know what they are saying,' just sayin'..." – Paid-up subscriber R.J.

"Regarding [Steve's DailyWealth article on brokers]... Great work, I've been following you since 1999. I am a financial advisor at Merrill lynch, and we have three lists of ETFs:

1. Safe to buy no restrictions
2. Unsolicited only (most leveraged or inverse ETFs fall here)
3. Blocked list (these are most of 3x funds and volatility ETFs, and those with horrible tracking error)

"Now self-directed clients can buy 1 and 2, while advisors can only recommend from list 1. List 3 is off limits unless certain criteria are met... Speaking with compliance, they don't want to be sued by clients that don't understand the products, so they restrict access. It's not that they can't buy, but they require extra paperwork..." – Paid-up subscriber E.M.

Brill comment: Thank you to all the readers who weighed in on the subject. To be clear, we understand why some brokers may restrict trading in leveraged funds or those that have a history of poor performance. But in this case, the exchange-traded fund Steve recommended was simply a basket of ordinary stocks... which leads us to believe it was restricted for a reason other than "due diligence."

Regards,

Justin Brill
Baltimore, Maryland
February 1, 2017