Only a couple of years ago, US economists were still worrying about deflation. And although this threat has certainly receded, price increases have been surprisingly elusive, especially given the unprecedented sums of money that central banks have poured into the market in the last decade. The biggest question mark in this cycle has been the almost total absence of inflation.
The Fed introduced a 2% inflation target in January 2012. Since then, its favorite inflation measure (personal consumption expenditures or PCE) has been above 2% for only 7% of the time. In contrast, between 1990 and 2011 – a period that included three recessions, PCE inflation exceeded 2% for as much as 60% of the time (the orange sections in the chart below). Inflation has become so lackluster that the Fed is even debating whether it should make its target more dynamic. The euro area is no different. Since 2012, inflation has been above 2% only 15% of the time, versus 49% between 1997 (start EMU data) and 2011. It is safe to say that markets have become accustomed to lower inflation.
There are signs that things are changing. The inflation-linked market is trying to tell us that the risk of inflation is picking up. The break-even inflation rate (BEIR), the spread between nominal and inflation-linked bonds, which reflects the market’s view on expected inflation has moved up steadily since last December. As this spread widens it becomes more expensive to buy inflation protection and US 10-year break-even inflation is now back above 2%. With the Trump government adding another dose of fiscal stimulus to an already ‘warm’ US economy, it’s not difficult to see why this market is preparing for higher prices. And a small shift in actual inflation can have a much larger impact on inflation expectations. From the perspective of bond investors this is what counts, especially when credit spreads are historically tight and leverage levels are rising. So little inflation for so long has lulled us into a false sense of security. And it may not take much to spook people – as we saw at the end of January – and derail the already diminishing Goldilocks scenario for bonds.
Bond markets have been focused on US core inflation (excluding food and energy) as this reflects the underlying trend in inflation. Last year, this surprised on the downside, due to lower mobile telecom and healthcare prices. In fact, for most of 2017, the bulk of core inflation came from rents. This is changing. Healthcare inflation is showing renewed signs of life and the prices of clothing and various services are rising too. Core CPI will likely reach 2% in April and even core PCE, which assigns less weight to rent, looks set to flirt with the 2% threshold. It is also important to bear in mind that this forecast is based on a bottom-up analysis of inflation. A top-down analysis, which includes tight labor markets and additional fiscal stimulus, suggests risks are to the upside. Based on this bottom-up inflation outlook alone, we expect four 25 bps Fed rate hikes this year, while the top-down trend means this could be more rather than less. The issue is not really whether a more serious inflation threat could cause the Fed to hike more, but whether market expectations can move out of their current comfort zone. This cycle has been so different – gradual growth, gradual inflation, gradual hikes – that any signs of normal cyclical inflation pressure could easily unsettle markets.
Europe is at an earlier stage in the cycle than the US. But, in Northern Europe labor markets are stronger and wages have started moving up slightly. For example, Germany’s IG Metall closed an important deal in February, lifting wages by 3.5% annually. The ECB appears pretty reluctant to respond to any initial signs of wage inflation – also because of the stronger euro, which would not be helped by higher rates. But will they even need to act? If bond markets fall because of a sell-off in the US, this will have a knock-on effect on bond yields in Europe.
During 2017, the general trend in emerging markets was one of declining inflation, with rate cuts in Brazil, Russia and Indonesia. This resulted in a rally in local bond markets. Notable exceptions to the trend of declining inflation were Mexico and China, where policy tightened.
But have we really been without inflation all this time? No. Just inflation in the traditional sense, as measured by rises in wages and the knock-on effect on consumer prices. We have seen ample inflation in house prices in many countries and if we look at financial markets, it is evident that assets there are in inflated territory too. This is what makes the shadow of inflation so threatening.So how can we position our funds for this environment? In the global fixed income funds, we actively manage duration and have adopted a more defensive stance to prepare for rising interest rates. While in our credit funds we have reduced beta and are keeping some ‘powder dry’ to be able to profit from sell-offs in names we like, as was the case in the most recent correction. We also have a clear preference for certain areas of the market. For example, financials are attractive in a rising interest rate scenario as this benefits banks and insurers. And as volatility picks up, our issuance selection should be able to benefit from increased dispersion in the market.
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