Investor views on the inflation outlook have swung wildly since the global financial crisis of 2008. Last year was a prime example. At the start of 2016, the consensus view was that we were headed for global deflation, which led to sharp falls in equity markets and bond yields. Later in the year, reflation was the theme driving market performance and equity markets and bond yields rose. The interesting thing was that last year’s U-turn on inflation was relatively predictable.
As the reflation view is entrenched, it is an ideal time to delve into the fundamental drivers of inflation to explore whether or not the reflation theme is valid and whether or not there is a risk of another lurch in inflation views. We will then consider the implications for markets, and discuss the risks due to policy changes by the administration of US President Donald Trump.
To get an idea of global inflation trends, we will focus on the US, given the importance of the US financial markets and economy that leads to US inflation trends dominating pricing on global markets. Also, many of the factors driving US inflation are reflected across the globe. There are two broad measures of US consumer inflation. One is the headline rate, which measures the price changes in a representative basket of consumer goods. The other is the core measure, which excludes food and energy from the headline rate. Both are important and need to be analysed separately.
The outlook for US headline inflation
The key driver of the change in inflation views last year were the swings in headline inflation. The plunge in oil from above US$100 a barrel to a low of US$26 a barrel shaved US headline inflation to below zero for much of 2015, leading to the deflation concerns that troubled investors at the start of last year. Given how a consumer-price index is constructed, however, unless oil prices kept falling, this phenomenon was only ever a temporary one. Once the price of a good no longer drops, it ceases to directly lower headline inflation after a lag of 12 months at the most.
By the middle of last year, oil prices had doubled to above US$50 a barrel. Assuming oil stabilised at these levels, it didn’t take much effort to see that the rebound would boost headline inflation over a 12-month period. At the time, we predicted that headline inflation would peak above 3% in early 2017. This in our minds would lead to significant inflation concerns on financial markets. This would work in a similar fashion to how the plunge in oil prices led to deflationary fears; investors would overestimate the impact of oil prices on the upside. So far, headline inflation has doubled since oil rebounded. It reached 2.5% in the 12 months to January – the fifth month in a row when the 12-month rate rose. A similar reflation occurred in other countries (with the focus on Europe and China), such is the influence of oil prices on consumer or headline inflation.
Since the low in oil prices was recorded in February last year, the doubling in oil prices won’t fully flow through into the 12-month reading of the consumer-price index until the number for the 12 months to February is released. This raises the question of whether or not the reflation theme will turn into an inflation scare. A headline rate higher than 3% might well do this. But as we close in on the release of the year-to-February result on March 15, it’s more likely that headline inflation will only peak at slightly above 2.5% for the period. Such a result would fall short of expectations for headline inflation to peak at 3% mainly due to the weakness in food prices that has offset some of the effect of higher oil prices. Such a result would be unlikely to rattle investors and would probably see the reflation trade remain in place, at least, in the short run.
The outlook for US core inflation
If headline inflation appears to be under control, investors will turn for confirmation to the core inflation rate, which so far has been stable even as the headline rate flip-flopped around – it rose 2.3% in the 12 months to January. Phillips curve-based models that are grounded in the trade-off between the unemployment and inflation rates successfully describe the dynamics of core inflation, by linking inflation to labour-market utilisation, energy prices and the currency. With the relative stability of oil prices and the US dollar expected to stay strong, this leads to divining the inflation outcome from measures of the utilisation of the labour market.
The US Congressional Budget Office estimates the natural rate of unemployment at 4.7%, the lowest the unemployment rate can go before it is boosting inflation. That’s about where the US jobless rate is now; it was 4.8% in January. Economic growth is expected to remain robust enough to allow the economy to create more jobs, supported in the near term by the large jump in confidence post the election of Trump that was largely based on his promised fiscal stimulus and regulation shredding. This would suggest growing pressure on wages and inflation as we move through the year, and is consistent with business surveys that suggest workers are harder to find. Later this year, we would expect to see core inflation accelerate to between 2.5% and 3%. However, given the near-term dynamics, the reflation theme should be largely priced in over the next couple of months. There is a risk of some disappointment in the middle of the year, however, as it may be later in the year for it to be clear an upward trend in core inflation is taking hold.
If core inflation speeds up as we expect, ultra-loose monetary policy would become inappropriate. We would expect the Fed to steadily lift the official cash rate over the next couple of years. This would also put upward pressure on bond yields. It is interesting that the general view is that there is a bubble in bond markets; that yields are unsustainably low. But when you consider the slope of the yield curve, which is still somewhat elevated relative to historical averages, it suggests the problem is not in the bond market itself but in the policy response to the global financial crisis – too much quantitative easing and negative interest rates.
The outlook for equity markets is more nuanced because they are a ‘Goldilocks’ asset. They struggle when inflation is too high or too low but thrive when price increases are moderate. Initially, the lift in inflation will be gradual, as the tightness of the labour market is likely to be moderate. In this environment, the positives (reflation lifting nominal growth and therefore profits) would be expected to outweigh the negatives. However, with the lift in US stocks over the past year or so, much of these positives have been priced in, seeing valuations somewhat stretched, and markets vulnerable to any disappointment. Also, in a rising inflation environment, the risk of an inflation scare destabilising equity markets is elevated.
The other issue for markets is that the unemployment rate hitting the so-called natural rate usually signals a worrying turning point in the business cycle. Generally, the jobless rate falling below the natural rate of unemployment points to a recession in a year’s time, unless a burst of productivity growth extends the cycle. This is where Trump’s tax reform and deregulation need to be watched as they have the potential to extent the business cycle.
Other policies of Trump may be less benign and thus inject uncertainty into the inflation outlook. Protectionism and the risk of trade wars could lead to inflation reaching troubling levels, while any geopolitical shock could destabilise markets. Also, within the potential tax reform is the introduction of a border-adjustment tax, or BAT, on which the administration has so far given mixed messages. A BAT is a tax levied on goods and services where they are sold. It is thus levied on imports to the US, while the country’s exports are exempt. In theory, a currency rises to offset the boost to domestic competitiveness. In reality, however, this is often not the case, leading to a rise in inflation due to an increase in the cost of imports. Much uncertainty surrounds Trump’s economic plans. We can say, however, that they probably won’t revive the concerns about deflation that were so prevalent a year ago.
Large swings in oil prices have an outsized impact on the general consensus on the inflation outlook. Falls and rises in oil prices show up in inflation measures over an extended period of time due to the fact that inflation is a measure of 12-month price changes. However, the market responds to inflation measures when setting the inflation outlook. Suchs large swings in oil prices can give a lead on where consensus on inflation is heading. This can be seen in the move to a reflation theme that dominates market dynamics today. This reflects the rise in oil prices in the first half of last year. The low in energy prices February last year, and subsequent rise, will have its peak impact on headline inflation in the February release (due in 15 March), giving further life to the reflation theme.
However, with relative stability of oil prices since the middle of last year, this impact will dissipate relatively quickly and the key to changes in inflation expectations will move from headline inflation to core inflation. With the fall in the US unemployment rate to the level believed to be the natural rate, and economic growth expected to be robust, we expect an end to the sideways trend in core inflation and a move to one of higher core inflation. In this environment, ultra-loose monetary policy will be inappropriate, and the resultant rise in the US Fed Funds rate would place upward pressure on bond yields. We believe that the positive reflation environment is priced into equities and they are vulnerable to disappointment should an inflation scare develop.
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