The specter of deflation is haunting risk markets
Expect the Federal Reserve to hold off on rate hikes as fear of a financial crisis grows
One thing stands out in another day of wild swings in equity indices: The worst performing sectors in the S&P 500 today are, respectively, Residential Real Estate Investment Trusts (-3.7%), Industrial REITS (-3.5%) and Office REITS (-3.5%).
These are supposed to be low-volatility income instruments that trade like bonds. They are supposed to rise when bond yields fall. The US 30-year bond today rose by almost 1 percentage point, and the broad equity indices closed with marginal losses. But real estate got crushed. That’s not a good sign. It says that investors don’t believe that home renters, office renters and industrial companies will continue to pay today’s high rents.
Bottom line: the Federal Reserve will put itself on perma-hold out of fear of financial crisis.
Shelter, the US Bureau of Labor Statistics estimates, makes up nearly 40% of US consumer expenditures, so a drop in rents implies a substantial decline in the overall price level. The Zillow Rental Index was flat year-on-year as of November, and today’s price action says investors think it will turn negative. The two worst days for residential REITS in the past five years were today and Christmas Eve, and the bond market rallied on both days. That can’t be good. As the chart below shows, REIT prices for the past year moved in the opposite direction of government bond yields, until the past month or so.
The Federal Reserve has been watching the collapse of inflation expectations, which follow oil prices. Since October 1, the expected inflation rate (change in the US Consumer Price Index) during the next five years has fallen from around 2.1% to 1.5%, as the so-called breakeven inflation rate implied by Treasury bond yields fell in lockstep with oil prices.
Most analysts have tended to dismiss the collapse in inflation expectations as a one-off event due to a drop in the oil price. But what if the drop in the oil price is not the result of supply and demand imbalances, but reflects a tightening of credit conditions leading to deflation?
It’s not a good sign when the S&P 500 and the price of oil trade together tick for tick.
A measure of credit tightness in the banking system is the spread between LIBOR, the rate at which banks lend to each other, and the rate at which the government lends to banks. Since the beginning of October, this spread has widened from about 0.16% to 0.4%. That’s a small increment, but it reflects rationing of lending among the major banks.
As the chart shows, the decline in the price of oil and the fall in the broad US equity market both track this gauge of credit tightness. It’s a fair surmise that the oil price collapse occurred in large part because banks pulled credit lines on customers stockpiling oil and forced them to liquidate inventories into the open market.
Oil and stocks are trading tick for tick:
The correlation of daily changes, moreover, is extremely close (over 60%). Falling oil prices are supposed to have a mixed effect on stocks. Oil producers lose, but consumer stocks benefit (because consumers have more money to spend on other things than energy). That was then. During the past three months, oil and stocks have traded nearly identically.
There ought to be a buying opportunity during 2019, and brave investors will venture in now anticipating that the Federal Reserve will do what the Federal Reserve always has done – backtracking when it finds itself in a minefield.