Trouble-Trouble

Tim Hortons has just brewed up a real storm. The Ontario government's move to raise the minimum wage, combined with corporate owner QSR's control of pricing, has caught franchise owners between a rock and a hard, stale donut. By arbitrarily cutting employee benefits, the company generated some seriously negative headlines across Canada. This callous and clumsy approach by Tims franchisees has been a classic case-study in bad P.R. management.

But are we guilty of shooting these messengers as they haphazardly respond to rapid changes in the cyclical environment?

Get used to it. This is just the beginning of cost increases faced by business. McDonalds has raised prices in Canada, responding to the 18% increase in their labour costs. And it is not just in Canada that prices are rising. Last month's reported U.S. CPI included strong gains for rental accommodation and health care costs. 'Sign on' bonuses to attract workers for U.S. truckers are now commonplace in a response to the shortage of workers. Gasoline is up 50 cts a gallon to the highest level in three years. Many U.S. companies have used the recent tax reduction windfall to announce special bonuses to their lowest paid workers.

The final stages of an economic cycle are always characterized by rising inflation expectations.

We are on the cusp of cost increases that will impact all labour intensive businesses. They will need to raise prices or face significant profit declines. The changes to the tax code in the U.S. are poorly timed, being late in the cycle. These will likely kick cost increases into a even higher gear. The lagged success of the grand monetary experiment begun in 2009 is now beginning to reap what it has sown.

Investors have begun to take notice. Witness the weak technical position of Restaurant Brands International, QSR-T, shown in the chart below. The stock is an obvious short, as evidenced by weakness in relative strength, money flows, and momentum. I believe the weakness is not simply due to the Tim Horton controversy, as it started well before the headlines. It is reflective of the rising cost problems that will present major headwinds for the entire consumer sector over the next few quarters.

Yield Aversion

In this part of the cycle, any increase expected inflation is rapidly translated into higher bond yields. With the flight-to-safety bid having evaporated, QE being wound down and the credit cycle peaking, the artificially suppressed yield environment is vulnerable. Future changes in the inflation premium should now start to dominate the return profile of bond investments.

The chart below is the '5 Year, 5 Year Forward' curve - the difference between 5 year yields and the 5 year forward yield of the same instrument. It is a 'derived' measure taken directly from the markets. It represents the forecast of inflation embedded in market prices. It has been rising steadily since mid-last year's deflation scare.

Financial Market Inflation Expectations:

Reported inflation (smoothed version) has also been rising over this same period and is nudging up to 3%.

U.S. CPI (16% Trimmed*):

Focus on last year's February/March sharp decline in the above chart. The Fed called this a 'transitory effect', blaming the decline on a one time decline in mobile phone costs (read last week's blog). Remember, CPI is a year over year reading. We already know the half data points in advance. These weak 2017 readings will be lapped in the upcoming March/April reports. Consequently, these CPI prints should be surprisingly sharp. The January reading should mark the low in inflation this year. The March reading, conversely, could be north of 3.5%.

We are seeing financial markets responding to the budding inflationary threat, but is the average consumer worried yet?

The University of Michigan Survey of Inflation Expectations, shown below, would argue not. This reading of consumer inflation expectations still exhibits a downward trend.

It has been slowly declining from the previously elevated levels as consumers have grudgingly come to accept the secular deflation argument. I believe the pending inflation reports, especially in Q2, should prompt an abrupt reversal of this complacency. As inflationary pressures begins to mount, bond yields will come under increasing pressure from fund outflows and perhaps even a redemption wave.

U of M Inflation Expectations:

But it isn't all clear sailing for the inflation bull case just yet. A fly in the ointment could come in the form of a sharp decline in energy prices during the next few months. The 'long oil' trade is crowded and seasonally vulnerable. For now, a strong global demand forecast, declining inventories and weak dollar are calling the tune for the energy bulls. Watch WTI carefully.

As well, strong secular deflationary forces of technological displacement and demographic downshifting are still present. Amazon just showcased 'Amazon Go', their new food storefront that has eliminated the check-out function. Its employee headcount just dropped again. These deflationary pressures will dominate over the long run.

I am simply arguing here for strong cyclical readings over the next year or so.

Should commodities strength continue to build, and labour cost pressure remain unchecked, inflation will be the surprise story for 2018. Cycle ending rate hikes by the Federal Reserve could ensue, causing a 2019 growth slowdown. For now, the parallel shift being experienced in the yield curve should not present a threat to stock price appreciation. The curve has actually steepened a bit over the last ten days. Only when the long end of the curve stops rising and the curve inverts, we will have the opportunity to short the broad averages with impunity.

Ultimately, Gold could rally strongly this year. It could be spurred by a perception that the Fed is behind the curve,especially if they are slow to respond to the inflation data. I haven't like gold's prospects this much in a long time.

Risk Model: 3/5 - Risk On

Although the VIX has receded from its high, it needs to calm down a bit more to set a positive tone. AAII Bull/Bear is still elevated, as the seasonal 'feel good' continues. Earnings estimates are still be revised higher on the release of company forecasts during the earnings report season, so its a hard tape to fight.

The Growth/Value rotation trade is still on the back burner as FOMO fully takes charge. The January surge of cash into ETFs and mutual funds (record inflows of >$40bn) is finding its way into the major averages during this melt-up phase. Despite the stretched momentum, (13.7% above the 200 day) the rally continues.

The negative effect of rising rates on equities will make progress tougher to achieve in the coming months. This will affect both 'bond proxy' and high multiple stocks more directly. Growth sectors should give way to a more selective and cyclical leadership before we are through with this market. We are still on track for a Q2 market peak.

* 16% Trimmed CPI: This version takes out the 'outlier' components and provides a smoother version more representative of the core inflation trend. Fed watchers contend this version is more influential than the 'whippy' basic CPI in policy formulation.