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Is Friday’s Selloff Something Significant?

Equites were hit hard Friday for a myriad of reasons.  First, the CPI data suggested inflation was starting to firm.  Second several earnings disappointments referencing the strength of the dollar.  Third Chinese growth issues and fourth Greek concerns.

Inflation, earnings, and the dollar are all interconnected.  Companies are valued by corporate cash flow (aka earnings) discounted by some interest rate.  If interest rates are thought to go higher to combat emerging inflationary pressures, valuations hypothetically fall.  It is evident that corporate cashflows are being impacted by the dollar, a dollar that should not fall in value given increasing odds of higher interest rates.

If the US increases interest rates and the remainder of the world is lowering rates, the dollar will not decline in value thus impacting the competiveness of US corporations’ hence negatively impacting profits.

The CPI narrative was steep in reference to oil.  Core CPI—or ex food and energy—was up 1.8% in March, the biggest 12 month advance since October.  Over the past three months core CPI was up 2.3%, the most since June compared with a 1.6% increase in February.  As all know the Fed’s inflationary speed limit is 2.0% and the closer the economy is to 2% the greater the odds of a change in monetary policy.

And then there is oil.  Oil is up about 30% since March 17.  Will these gains hold? How will these gains impact other inflationary pressures?  Medical costs are up 0.4% in March, the biggest increase since August 2013.  OER or the category designed to tract the rental value of owner occupied housing and is a huge component of the CPI rose 0.3%, the most since December 2013.  Used auto prices had the biggest gains since 2011.

Commodities, led by oil, are vastly under owned.  The textbook allocation of commodities in a fully diversified account is around 5% to 7%.  Today 1% to 1.5% is allocated to commodities given the deflationary and oil narrative.

Commodity markets are relatively illiquid as compared to all other markets, thus suggesting large swings are possible given strong buying (or selling).

I rhetorically ask what happens to commodities if pricing pressures continue to rise which would may then trigger defensive buying of commodities as an inflationary hedge which then translates into greater inflationary pressures in general goods and services which is then reflected in the popular inflation indices, all amplified by rising OER because of increasing home values and rising wage pressures?

Wow!  I wrote the above paragraph and sound confusing and complex.  However, the above is the genesis of demand pull inflation that has periodically impacted the economy.

Maybe Friday’s sell off can be taken as something of significant.

I have little comment about Greece or China other than the impact of both waxes and wanes on given the events of the week.

What will happen this week?  The economic calendar is sparse containing several housing data points and regional manufacturing statistics.  The earning season becomes more active as over a 100 S & P 500 companies post results.

Last night the foreign markets were mixed.  London was up 0.73%, Paris up 0.46% and Frankfurt up 1.62%.  Japan was down 0.09% and Hang Sang down 2.02%.

The Dow should open moderately higher as China’s central bank cut banks’ reserve requirements by the most since the global financial crisis.  Earnings are generally exceeding the very dumbed down expectations but the consistency with the earning’s reports is the impact of the dollar.  The 10-year is off 2/32 to yield 1.88%.

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Ken Engelke

Chief Economic Strategist Managing Director

The views expressed herein are those of Kent Engelke and do not necessarily reflect those of Capitol Securities Management. Any opinions expressed are statements of judgment on this date and are subject to certain risks and uncertainties which could cause actual results to differ materially from those currently anticipated or projected. Any future dividends, interest, yields and event dates listed may be subject to change. An investor cannot invest in an index, and its returns are not indicative of the performance of any specific investment. Past performance is not indicative of future results. This material is being provided for informational purposes only. Any information should not be deemed a recommendation to buy, hold or sell any security. Certain information has been obtained from third-party sources we consider reliable, but we do not guarantee that such information is accurate or complete. This report is not a complete description of the securities, markets, or developments referred to in this material and does not include all available data necessary for making an investment decision. Prior to making an investment decision, please consult with your financial advisor about your individual situation. Investing involves risk and you may incur a profit or loss regardless of strategy selected. There is no guarantee that the statements, opinions or forecasts provided herein will prove to be correct. If you would like to unsubscribe from this e-mail distribution, please reply to this e-mail and indicate that you wish to unsubscribe in your response.