Stock markets have reached a plateau, but not a high one. Sentiment seems entrenched around the view that something bad is about to happen in the world despite the macro economic information being published. We look at how inflation may surprise as the impact of low energy prices works out of the year-on-year numbers.
"Stock prices have reached what looks like a permanently high plateau", stated Irving Fisher, the (otherwise) brilliant economist, three days before the Wall Street Crash of 1929. We saw similar sentiments expressed during the internet boom: remember the 1999 bestseller, Dow 36,000: The New Strategy for Profiting From the Coming Rise in the Stock Market? At the moment we are seeing sentiments that are similarly entrenched but, unfortunately, in the other direction. It’s called the ‘New Normal’, a new era where we fail to generate much economic growth, we fail to benefit from innovative technologies, productivity falls, poor demographic trends kick in, inflation stays low, interest rates stay low, investment returns take a step down… you get the message.
Whether this depressed state is permanent is the crucial question. Some capital markets certainly think so. Government bond yields are implying very low growth, and inflation markets are implying very modest price increases, into the very distant future. This does not fit the evidence, however. For example, once volatile energy and food prices are stripped out, ‘core’ US inflation is actually on a rising trend and has been for the past year. Moreover, the rise in prices is occurring largely across-the-board. Housing costs grind higher, medical expense inflation is accelerating, services inflation is climbing and even goods prices, which tend to deflate over time (a benefit of competition among international manufacturers), have bounced. If we were really in a deflationary world, you might expect most categories of expenditure to be falling in price. "Whatever his political background, the Mayor must ensure that our areas of success and effectiveness are not just protected, but promoted and enhanced."
The picture changes if we re-include energy and food prices, to arrive back at the more commonly-used ‘headline’ measure of inflation. Energy prices are a big component of this measure of inflation, and have been plunging, dragging it down. The chart demonstrates the difference between US core and headline inflation: headline US inflation is growing annually by only about 1% (having not grown at all for almost a year), whereas core US inflation is already growing at between 2% and 2.5% annually. Rather than diminish the outlook for inflation, however, this discrepancy actually cements the likelihood of an increase! Oil prices cannot continue falling forever – indeed, they have already rebounded substantially from their lows earlier in the year. As a result, the drag from oil is actually going to turn into a mild push as the year continues. By that time, both measures of inflation will be showing significant annual increases.
A COMPARISON OF HEADLINE AND CORE INFLATION IN THE US
One of the main causes of price increases is wage increases, which add to the spending power of consumers and their demand for goods and services. The evidence here is also in favour of an upwards inflation trend. Over the past year there has been an uptick in US wage growth to about 2.5% per annum, the highest it has been for six years. This is a lacklustre growth rate by long-run historic standards, admittedly, but the point is not that inflation is going to steam ahead, however, but that there is any at all, given the complacency of markets. For this reason we are reasonably confident that inflation expectations are under-priced. This may be due to a strange relationship that has developed between the price of oil and the market’s expectations for inflation. Though oil is only a part of the basket of goods tracked by inflation statistics, it has come to dominate inflation expectations. Consequently, inflation expectations, even those looking out 30 or 40 years, have been moving up or down largely in line with changes in the current price of oil! This strange relationship reached such an extreme in February that US Federal Reserve Bank officials highlighted, in a piece of research, "According to our calculations, oil prices would need to fall to $0 a barrel by mid-2019 in order to validate current inflation expectations".
A surprise change in inflation expectations could impair bond and other interest-rate sensitive assets quite dramatically. One solution is to own index-linked bonds, whose values are influenced not just by interest rates but also by inflation expectations. The problem here is that the two effects can offset each other: the inflation-linked component could be gaining in value while the interest rate component might be losing value. Investors will never know in advance which will have the greater influence. For this reason we have chosen to replace our index-linked government bonds in favour of a direct investment in US inflation expectations. This investment is both simpler and a more effective insurance mechanism: it will grow in value if inflation expectations rise, and will shrink if they fall.
Chief Investment Officer
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