When does inflation begin to change investment decisions?
During the first quarter of 2017 we removed U.S. inflation from our outlook and reverted to Stagnation for all global economies for the twelve-month forward forecast. Looking to the future, our analysis suggests that ongoing monetary accommodation is unlikely to have significant inflationary consequences, if inflation expectations remain anchored. As we enter the second quarter of 2017, we are redefining our Inflation environment to U.S. CPI1 greater than 3.5%, up from the previous 2.7%. We will review this as the economy grows, and as underlying inflation and interest rates move higher.
With U.S. macro data coming in strong and further evidence that price pressures are building, the uptrend in bond yields appears likely to continue. As the focus of rising yields is primarily to manage the rate of growth of an economy and inflation, we believe it worthwhile to review the traditional and current relationships between growth, productivity, inflation, bond yields and equities. The recent rising trend in bond yields has been positively correlated with continued gains in equities, which we relate to a low inflation environment.
Advanced economies have experienced a prolonged episode of low interest rates and low growth since the global financial crisis. From a longer-term perspective, real interest rates have been on a steady decline over the past three decades. Despite recent signs of an increase in long-term yields, particularly in the United States, the experience of Japan suggests that an exit from a low interest rate environment does not come with a play book. A combination of slow-moving structural factors, including population aging and slower productivity growth currently plaguing many advanced economies, are generating a steady state of lower growth and lower nominal and real interest rates in these countries. With the second Fed hike in December and the expectation that the Fed will soon begin to shrink their bond portfolio, the market will judge whether the tighter financial conditions will impact growth. Challenging the impact of the rate hike is the impact of the stronger U.S. dollar.
U.S. Payroll employment started the year on a strong note, with monthly gains in both January and February well above 200,0002. Rising labour costs helped drive core inflation above 2% but these costs are rising faster than selling prices in the non-financial corporate sector. Is the U.S. economy growing fast enough to support higher interest rates?
Expansion of central bank balance sheets has produced a multiplier effect on U.S. equity returns. This has impacted confidence which fed into soft data, namely business and consumer confidence, the measures of expected growth for the U.S. economy and inflation. Hard data, such as payrolls and industrial production, have not been as encouraging. The gap between “hard” and “soft” data measuring the U.S. economy has never been wider3.
Rising Yields from Low Levels Remain Friendly for Equities
A slowdown in productivity tends to be deflationary at the outset and inflationary later. Initially, lower productivity growth reduces investment, pushing down aggregate demand. Lower productivity growth also reduces consumption, as households absorb smaller real wage gains. Stabilization of inflation may imply a shift in economic volatility to other variables, helping generate asset-price booms by making borrowing and risk-taking more attractive. It may also raise the return to capital by restraining wage growth.
There is good reason to question the view that lower unemployment will push wage growth substantially higher in the current environment.
Such results could be explained by the fact that in a very low yield environment, higher yields are perceived as an indication that the economy is improving, which also benefits equity prices. Central banks have debated what the inflation target should be. The first inflation target was adopted by the central bank of New Zealand in 1990. The Fed used an unofficial inflation target until January 2012, when it announced that it thought a policy which targets a 2% rate of inflation is consistent over the longer run with the Fed’s mandate4. Looking ahead, three structural forces look set to keep us in this low yield environment over our forecasting time horizon of the next twelve months; technical change, flexible labour markets and globalization. We examine this question in further detail in our third Whitepaper available on our website.
How should the Fed respond?
Two Federal Reserve Board economists, Michael T. Kiley and John M. Roberts, suggested three ways for the Fed to avoid zero interest rates as much as possible5. We prefer their suggestion to set the inflation target above 2% with the Fed keeping an eye on the weighted impact of all capacity constraints currently present. This is based on our recent conclusion that structural forces will prolong the deflationary forces currently in play.
Headline inflation in the developed world is likely to rise in early 2017, due largely to rising oil prices and a generally firmer global backdrop. Underlying inflation would rise slower as above-trend growth eats away at available slack. Interest rates will likely remain low in many economies, and will not rise substantially in the U.S. in the coming years. A year ago, a drop in aggregate demand caused a decline in global goods prices. Stimulus from the BOE, ECB and BOJ was used to fight this trend and contributed to growth.
The recent rebound in inflation is attributed to previous falls in oil prices, a process which has now almost finished. Long-term inflation expectations pulled back in most advanced economies over the past month while headline CPI inflation in major emerging economies continued to fall in February. Emerging markets still struggle while bigger economies are stabilizing.
We conclude that pressures on productivity and demographics will keep inflation pressures and growth in the U.S. and globally at levels within our Stagnation Environment definition for a period extending well beyond our twelve-month forecast horizon.
Themes
1. A Brighter World Economic Outlook
The world economy has entered Q2 in better shape than it exited 2016. It has now been confirmed that global GDP growth accelerated in each quarter of 2016 and was close to 4% in Q4. However, there is still notable divergence in performance among G7 economies. The United States, U.K. and Germany grew by an expected 2% annualized in Q1, while France and Italy are expected to have grown at around half that pace. In the euro-zone, production grew by nearly 1% in January, and industrial output in Japan has surged over recent months. The latest output data for the major emerging economies have been mixed. GDP trackers point to a renewed downturn in Russia while information out of China suggests that the improvement in growth seen over the past year or so has fizzled out.
Headline inflation has rebounded in every major economy. In developed markets, monetary easing is on it’s way out while emerging market central banks plan to continue cutting their policy rate. Among central banks this year, 13 have cut their interest rates while five have raised them6. The unweighted global average policy rate dropped below 2%, an all-time low, while world inflation jumped to 2.5% due to energy prices, resulting in negative real global policy rates7.
The unemployment rate in the OECD fell to 6.1% in January, its lowest since 20088. Employment growth has slowed in the U.K. in recent months, but has continued at a steady pace elsewhere. Euro-zone employment has finally recovered to levels seen prior to the global financial crisis.
The IMF published its twice-yearly health check on the world economy. The outlook has brightened considerably since an interim forecast in January. Signs of stronger activity are visible in both developed and emerging markets. Forecasts for worldwide GDP growth are expected to be revised upwards. Christine Lagarde of the IMF recently noted that after six years of disappointing growth, the world economy has a “spring in its step”. The outlook could be revised because of political uncertainty (Marine Le Pen might win in France), protectionism (Donald Trump might start a trade war) and tighter global financial conditions (the Fed might raise interest rates too quickly). For the first time since the recession, there are a lot of things going well.
2. U.S. Growth
The latest data indicate that first-quarter GDP growth was relatively subdued at 2% annualised. That said, a lot of the weakness can be traced back to a sharp drop in utilities demand stemming from the unseasonably mild winter. The sudden post-election weakness in bank lending is a concern. Most of the market and media attention has focused on business loans which, after growing at a double-digit annualised pace between 2014 and late 2016, have suddenly stagnated while other major loan categories also show a marked slowdown in growth since last November.
A fundamental shift in trade policy over the next four years is being proposed by the new administration to stem the further outsourcing of manufacturing production and employment abroad this year. The reality is that only a small fraction of the five million jobs lost since China’s shift fifteen years ago to largest importer to the WTO could conceivably return. Also, assuming the U.S. becomes much more aggressive in initiating disputes at the WTO, we would expect other countries to retaliate by bringing their own claims. Meanwhile, the boost to the domestic manufacturing sector should be minimal if these new trade policies trigger a further appreciation in the dollar.
Changes to U.S. fiscal policy are not expected to take effect this year, eliminating their potential boost to growth. The combination of proposed fiscal stimulus and higher trade barriers in 2018 will likely add to inflation expectations but this may be offset by changing technology, labor markets and unstoppable globalization. American companies with large global footprints will suffer relative to domestically focused firms. We have positioned for this change by emphasizing small caps at the expense of large caps with our U.S. equity exposure. Small caps are traditionally domestically geared irrespective of their domicile. U.S. small caps face a potential additional benefit if the new administration follows through with promised corporate tax cuts. Small caps would benefit disproportionately given that the effective tax rate of multinationals is already low.
3. The Low Yield Environment Prevails
At its March 2017 meeting, the FOMC voted to raise the federal funds rate, the second increase since 2008’s financial crisis. However, the rise in government yields came to a halt after the FOMC talked back the future pace of hikes causing investors to scale back their expectations.
At the same time the continuing accommodative approach to monetary policy outside of the U.S. and the stronger U.S. dollar will likely lead to more foreign buying of U.S. Treasuries. This would bid up prices and drive down yields, a headwind for the Fed.
4. Monetary Policy
Historically, changes in real interest rate differentials have been the dominant driver of currency
movements in developed economies. In addition, growth in the dollar value of trade has been stronger, buoyed by higher commodity prices. Monetary policy expectations between the Fed and other G7 central banks should keep the US dollar strength in place. A stronger dollar is both a blessing and a curse for margins. All else equal, it lowers the cost of imported goods and thereby boosts margins for import-intensive firms, while undermining profits earned overseas.
With 44% of S&P 500 revenues generated outside the U.S., the net impact of dollar strength is negative for overall corporate profits. Stronger growth is required to offset the negative impact on profits from a rising dollar.
With these themes in mind, we will continue to monitor economic data for traditional slow growth signals from employment, consumer spending, business sentiment, Fed policy, the yield curve, inflation, and global economics.
Frame Global Asset Management considers these trends and factors them into our outlook for the economy in our twelve-month forward period. We look back to periods of similar economic behavior and use this information to predict the future behavior of the asset classes that we consider. Our investment process allows us to adapt for non-traditional monetary policy and other exogenous variables.
Deborah Frame, CFA, MBA
President and Chief Investment Officer
[1] Inflation measured by Consumer Price Index (CPI) is defined as the change in the prices of a basket of goods and services that are typically purchased by specific groups of households.
[2] Capital Economics. Non-farm payrolls rise 227,000 in January and 235,000 in February.
[3] FT.com. Morgan Stanley flags ‘record gap’ between hard and soft US economic data.
[4] The Economist. Why the Fed targets 2% inflation.
[5] Kiley, Michael T. and Roberts, John M. 2017. “Monetary Policy in a Low Interest Rate World.” Brookings Papers on Economic Activity. BPEA Conference Drafts, March 23–24, 2017.
[6] Canaccord Genuity. Canadian Focus List. April 4, 2017.
[7] Canaccord Genuity. Canadian Focus List. April 4, 2017.
[8] OECD Harmonized Unemployment Rates. News Release: January 2017. Paris, 9 March 2017.
