CPI: The Underestimation of Inflation?

by Brad Houle, CFA Executive Vice President

Inflation is an obtuse concept to fully comprehend. For the month of September, the Bureau of Labor Statistics indicated that the rate of inflation, as measured by the Consumer Price Index (CPI), was 1.7 percent for the last year. This would hardly be considered a noticeable price increase for most items. As a consumer, it seems that everything other than flat screen televisions is more expensive all the time, particularly if you consume prescription drugs, go to the doctor or pay for any type of tuition.

It is a fairly consistent complaint among the investment community that the CPI understates the rate of inflation. In fact, there are often conspiracy theories around the measure of inflation because the CPI is the basis for cost-of-living increases for Social Security recipients and other government payments to individuals which is consuming an ever greater percentage of the national income.

In looking at the detail of how the CPI is calculated, it is apparent that a great deal of thought went into the methodology while its value in measuring the true rate of inflation is questionable. As for the conspiracy theories around the inflation measure, it is unlikely that a giant bureaucracy is organized enough to pull off anything like that. No doubt well-meaning people work hard to produce these statics.

Too much or too little inflation is a bad thing. Excess inflation, such as was experienced in the late 1970s in the United States, or hyper-inflation that often occurs in developing nations can create an environment where costs spiral out of control. Conversely, negative inflation or deflation is also a troublesome scenario. In deflation, prices continually drop and as a result, consumption also goes down as consumers wait for lower prices. Japan has suffered from this condition to some degree for the last decade and is attempting to climb out deflation via aggressive economic stimulus.

Following aggressive monetary policy action taken by the Federal Reserve following the financial crisis, there was great concern that excess inflation would follow. Thus far, there has been no excess inflation despite the flood of liquidity put into the financial system to stimulate the economy. In fact, inflation is below where the Fed would like to see it. The Fed's preferred measure of inflation called the PCE Deflator which last month has a yearly increase of 1.5 percent and generally is lower than the CPI. The primary difference between the two measures of inflation is the PCE Deflator allows for the substitution of goods by consumers. The Fed would like to see the PCE Deflator closer to 2 percent.

The attempt to control and measure inflation produces more questions than answers. Inflation is very difficult to quantify and measure. There is no such thing as an average consumer and people are going to experience inflation very differently depending upon their stage in life and level of income. We believe that inflation is muted due to the long, slow recovery we’ve experienced since the financial crisis. The slack in the labor market and broader economy is just now beginning to get wrung out.

Our Takeaways for the Week

The equity markets were strong this week, up around 3 percent as we move through third quarter earnings season. According to data compiled by Bloomberg, about 79 percent of S&P 500 companies that have posted quarterly earnings this season have topped analysts’ estimates for profit, while 60 percent beat sales projections. In addition, the hysteria around Ebola now being called “Fearbola” has hopefully subsided.

Disclosures

Sanford and Son: Bonds Hit a Rough Patch

by Brad Houle, CFA Executive Vice President

Sanford and Son was a TV series in the 1970s about a disagreeable junk dealer and his adult son. In one reoccurring gag in the series the main character, Fred Sanford, would dramatically grab his chest and exclaim, "Oooo….It’s the big one….You hear that, Elizabeth… I'm comin' to you."  This simulated heart attack was perpetrated by the Fred Sanford character to make his point when exasperated and was always a false alarm. Recently, the junk bond market hit a rough patch with investors exiting junk bond funds, causing bond prices to decline. The question at hand is, is this correction "the Big One," meaning a new credit crisis, or simply a minor correction akin to the dramatic fake heart attack that Fred Sanford used to torture the other characters on the show?

Bonds that are below investment grade are often referred to as junk bonds due to the lower credit quality of the companies issuing the bonds. Junk bond is somewhat of a pejorative description of an important part of the bond market. Small companies that are growing, which is a large engine for the U.S. economy, often fit into the category of below investment grade credit. It is important that there are public market debt financing options available for these entities. Because of the lower credit quality, investors demand more compensation in the form of interest in order to loan these companies money. Also due to the lower credit quality, there is a higher potential default risk for these bonds.

Recently, there has been an outflow of money from high yield bond funds as investors have become nervous about the risks of below investment grade bonds. With interest rates being so low for an extended period of time, the hunt for yield by investors has been intense. Money has been flowing into the type of investments that can offer a higher income than the traditional bond market. Below investment grade bonds have been one of the asset classes that has benefitted from this cash flow. As a result, the prices of high yield bonds have been bid up and the resulting yields are down because they move inversely to one another.

The higher the risk in a bond, the higher the yield should be to compensate for the risk. The way risk is measured in high yield bonds is the yield spread over U.S. Treasury bonds. Bonds issued with the full faith and credit of the U.S. Government are considered to be riskless with respect to default. High yield bonds can default and, as a result, investors receive additional interest over a treasury bond to compensate for that risk. For example, if a U.S. 10-year Treasury bond is yielding 3 percent, a high yield bond should yield 8 percent, given the historical relationship. Traditionally, the average spread between high yield bonds and U.S. Treasury bonds is 5 percent. With the insatiable demand for income, high yield bond prices have risen to a point where investors are only getting 3 percent more interest than treasury bonds.

Our view is that this is a normal correction that has more to do with the recent stock market volatility than credit quality. The high yield market is often more closely correlated with the stock market as opposed to the bond market.  On average, the underlying credit quality of high yield bonds is better than average as evidenced by the default rate. According to Standard & Poor’s, the default rate on high yield bonds has recently been around 2 percent, well below the long-term average of just over 4 percent.

With the strong demand for high yield bonds, the valuation probably did get extended; however, we don't believe this is the start of another credit crisis.

Our Takeaway for the Week

• Geopolitical events continue to drive equity and bond market volatility

Disclosures