Tide turning on inflation - and adjustments will follow
While the global economy delivers on growth, the signs are there from the US regarding the pressure of inflation as the Fed raises rates, coupled with indications of wage pickup across the world. The RBA remains in a holding pattern on rates, and won’t move until the unemployment rate drops further.
After some consolidation in March where tariff war noise dominated the good fundamental backdrop, yields spent most of April moving higher, driven mainly by the US. Without the fear of trade wars, the underlying position of the US economy was allowed to shine through — namely that the US Federal Reserve is raising interest rates as fiscal stimulus is being applied to an already humming US economy. Inflation is a risk and yields are rising.
There is a lot to like about the global economy. We are seeing synchronised above trend global growth as the deflationary shocks of Europe (2011-12) and emerging markets (2015-16) have subsided, which has allowed the global economy to deliver its strongest years of growth since 2011. Extremely accommodative monetary policies finally are bearing fruit and the global economy is reflating.
Despite the signs of the return to the global business cycle, the sluggish expansion and low inflation since the financial crisis has led to a broader reassessment of the underlying economic structure. The need for persistently low policy rates in the face of premature fiscal tightening and private sector deleveraging, in addition to more structural demographic and debt load headwinds, reinforced the notion that equilibrium interest rates have fallen sharply and raised conviction that inflation would remain depressed even as labour markets tightened. With the link between growth and inflation perceived to have broken, markets still do not see central bank policy stances normalising much in the foreseeable future.
If we are right then the shift will begin with a reaffirmation of the laws of supply and demand, prompted by rising consumer price and wage inflation. Global core inflation remains low but the tide is starting to turn. US core Personal Consumption Expenditure (PCE) inflation is approaching the Fed’s 2% target, rising to 1.9% in March. At the same time, robust labour markets across most of the world are promoting a long-awaited pickup in wage inflation. The latest signal comes from the US reading of labour compensation growth jumping in Q1-18 to its fastest pace of the expansion.
The improved growth and inflation backdrop will promote a reassessment of the view that equilibrium real interest rates have fallen to zero or lower. Rather, we believe developed equilibrium real interest rates are at about 1%. Combined with 2% inflation targets, nominal policy rates thus should be trending toward 3%. The market perception is that no developed policy rate will reach 3%. This outcome is set to be challenged and we expect global interest rates to rise accordingly. In addition to rising short-term interest rates closely connected to central bank normalisation, long-term interest rates also will move up as views of equilibrium rates and inflation risk reset. The recent rise in US 10-year yields reflects each of these developments.
Among developed central banks, the RBA is one of the most inclined for an extended slumber. The Bank left the cash rate unchanged yet again, and as universally expected. The RBA remains optimistic on the outlook for the Australian economy, with GDP growth projected to be above 3% in 2018 and 2019. But with inflation remaining low the Bank has scope to be patient with respect to policy. The RBA will need to see further progress towards an unemployment rate of 5% and inflation forecast heading towards 2.5% to consider any upward adjustment in the cash rate.
The recent move higher in Treasury yields has shifted the attention of market participants to the risk of a double whammy to credit assets from higher rates and wider spreads. To the extent the trajectory of rates maintains a reasonable speed and, more importantly, continues to reflect a supportive growth, inflation and policy mix, we expect spreads will remain well behaved. Leaving aside the risk of a flow-driven dislocation, an abrupt rise in inflation remains the key fundamental risk to the credit spread/interest rate correlation. Despite the recent volatility, valuations on credit assets remain expensive. As policy rates rise and central bank liquidity is withdrawn market risk premiums should adjust, creating more value in riskier assets. We have been well positioned for this repricing by running low credit exposure and below benchmark duration.
With yields rising and credit spreads a little wider over the past few months we have taken the opportunity to add back some duration and credit exposures. While bond valuations have improved, we are continuing to hold a shorter duration position vs benchmark. Most of our short position has been held in the US where the policy cycle is most advanced and inflationary pressures are building. We continue to hold short duration positions in both Europe and Australia given improving economic cycles and poor valuations, but remain cautious given both central banks need to see further developments on the inflation front to consider tighter policy. Across credit we prefer Australian credit over global, for its high quality, short tenor and better valuations. We remain defensive on global credit and higher yielding credit and look for a meaningful repricing of spreads before we invest. Overall, the portfolio is well placed for higher volatility in the form of higher yields and wider credit spreads as markets reflect a more normal economic and policy environment.
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