Expect inflation expectations to be a big driver of fortunes in 2020

With political tensions heating up again in the Middle East, the oil price is likely to find a bit more support as stockpiles are increased around the world just in case something goes really wrong. A firmer oil price would help to firm up inflation expectations which could have big implications for stocks. In my New Year's Eve interview with Jim Goddard at HoweStreet.com, I explain my view that inflation expectations will likely be a key driver of returns in the coming year.

The first segment of the interview is more-or-less a general banter about the year gone by. The investment relevant content in the interview starts in the second segment at the 8:52 mark. That is when I begin to make the case that the strength of the Fed's determination to persistently hit its inflation target will be a key, if not the key, driving factor for stocks in 2020, especially Canadian stocks. If the Fed succeeds at boosting inflation expectations, it could be an explosive year for Canadian equities, particularly across oil & gas and mining. If the Fed fails, it could well mean a repeat of what we experienced in 2018.

Howe Street Interview released Dec. 31, 2019

The importance of inflation expectations can be seen with the mid-cap focused INK Canadian Insider Index. It has over a 70% correlation with changing inflation expectations. The chart below looks at the relationship between the one-year INK CIN Index returns (red line) and changes in the 10-year breakeven yields for Treasury securities in the US (blue line) which is a measure of long-run inflation expectations. It is pretty clear from the chart that rising inflation expectations and rising INK CIN Index returns go hand-in-hand.

INK CIN is once again leading the market as inflation expectations have turned up (click for larger)

The INK CIN pulled back sharply from its all-time high in 2018 as inflation expectations collapsed on the back of a tightening Fed. The central bank has not only reversed its direction from last year but, with its T-bill buying program which started in October of last year, it has signalled that it is getting serious about meeting its inflation target. The INK CIN has been leading the market since the program started October 15th, and the direction of inflation expectations is almost all you need to know to explain why. As shown in the chart below, 10-year break-evens since October 15th have been heading up.

Inflation expectations have been marching higher since October 15th (click for larger)

A lot is riding on the Fed's reflation efforts and we will be keeping a close eye on the breakeven chart above and whether insiders, particularly in the oil patch, are taking money off the table or putting it to work.

I have also come across some fantastic interviews on Real Vision that discuss inflation and their potential impact on assets markets. Jim Grant's kick-off interview for the new year gets right into the potential triggers for inflation.

Jim Grant on inflation triggers and more

Earlier in December, Rich Ross who is managing director and head of technical analysis at Evercore ISI gives us his outlook for potential winners in 2020. In his overview, he explains why he believes that the outlook for commodities, particularly oil, is tied to the direction of inflation expectations.

Inflation a key for a commodities breakout

We already had our sights trained on inflation expectations before the Trump missile attack on Iranian Major-General Qassem Soleimani. If crude oil fails to settle down after the news, like it did when Saudi Arabian oil facilities were attacked in September, inflation expectations could move higher more quickly than even we expected. That would be very bad news for the US equity market as oil price spikes tend to increase the perceived risk of recession.

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