The efforts of major central banks to generate inflation are finally starting to pay off in much of the developed world; a trend that will be boosted further by the increased role of fiscal policy in 2017.
The fear of deflation has cast a long shadow over the developed world for the past decade. Finally, however, the narrative seems to be shifting in the opposite direction. With the notable exception of long-suffering Japan, gone are the concerns of falling prices. Suddenly financial markets are convinced inflation is taking root, with Donald Trump’s US election victory helping to cement this view.
Government bond yields, after hitting record lows in the summer, have risen sharply as investors begin to price in a normalisation of inflation. The yield on ten-year US Treasuries, for example, jumped from 1.4 per cent in early July to 2.6 per cent in December, although it has since fallen back to 2.4 per cent.
Investors are right to have factored higher inflation into bond valuations. Indeed, given the strength of the US economy – not to mention the magnitude of the fiscal boost it is likely to receive once Trump has moved in to the Oval Office –this ‘re-pricing’ of government bonds is likely to have further to run.
With the US economy now growing faster than its trend rate, the annual rate of inflation as measured by the Consumer Prices Index is forecast to rise to 2.3 per cent in each of the next two years, from 1.7 per cent presently. While that might not sound like a dramatic increase, bear in mind that it stood at just 0.8 per cent in July and was actually negative as recently as September 2015.
Inflation is increasing in China too, with manufacturing output prices now rising at the fastest pace in five years. Inflation has recently picked up in the euro zone too, although Japan remains an altogether different story.
The gradual return of inflation is largely explained by two factors: the stabilisation and recovery in commodity prices and the actions of the world’s major central banks. Over the last year, all of them have kept monetary policy extremely loose. Indeed, policy has been loosened further in most places, including the euro area, UK and Japan. The case for easier policy was not difficult to make. While each of these central banks was dealing with slightly different issues, they were all in need of more inflation.
As for the one major country where policy has actually been tightened – the United States – even here policy has arguably been too loose. The Federal Reserve, by deciding to pursue a risk-management approach that aimed to cement the economic recovery and push inflation back up to its target – something we expect other central banks to do in the future – has probably not hiked rates enough. As a result, US inflation appears likely to overshoot its two-per-cent target.
At the same time, there is an increased likelihood fiscal policy will be used as a tool to boost investment and growth, further buoying reflationary forces. The International Monetary Fund in its April 2016 World Economic Outlook called for a three-pronged approach to securing higher and sustainable growth: structural reforms, monetary accommodation and fiscal support.
Last year, Japan, Canada and China all announced large fiscal stimulus packages. And most significantly of all, Trump has promised a massive expansion. One of the big questions for investors now is whether Trump will be able to deliver the level of fiscal stimulus markets are expecting. While the big cuts in individual and corporate taxes, and increased expenditure on defence, he is proposing are likely to be welcomed by Republican lawmakers, the tax reforms at least will take time to pass through Congress. As for his plan to boost infrastructure spending, that will require a change of attitude from some members of Congress if it is to come into effect. In any case, it will take longer still to deliver.
Nevertheless, we expect his policies to result in a fiscal stimulus of around 0.5 per cent of GDP over the next couple of years. And it could be even bigger with respected independent analysis of all of Trump’s pledges suggesting the annual boost to GDP could be double that.
With the US economy already close to full employment – the unemployment rate is just 4.7 per cent – hourly earnings are now rising at the quickest pace in seven years. A fiscal stimulus of the magnitude being proposed looks certain to boost wage growth, and hence inflation, even more.
However, it is important to remember that while Trump’s policies have the potential to ‘turbo-charge’ reflation; inflation itself remains low by historical standards. At this stage we do not envisage a more destabilising rise in inflation.
Crucially, there is no reason to believe the Fed is in danger of making a major policy error, by leaving interest rates too low and letting inflation get out of control. It is possible the Fed’s overly cautious approach to raising rates may persist for a little longer as it waits to see just what the incoming president does. But with at least five of the Fed’s 17 policymakers appearing to have raised their forecast for interest rates since September that looks unlikely.
To the extent there is a risk of inflation spiking significantly higher than we anticipate, the biggest threat, at least in the short term, would appear to come from a further leap in commodity prices. Stronger economic growth and higher infrastructure spending could conceivably coincide with supply shocks caused either by geopolitical tensions or output cuts from members of the Organisation of Petroleum Exporting Countries.
We saw a sixfold increase in oil prices between 2004 and 2008. While we do not envisage a repeat, that period demonstrated just how dramatic an impact an increase in demand can have on a market where supply is constrained, at least in the short term.
Looking further ahead, rising protectionism could pose a threat. We are more uncertain than usual about the political and policy environment under a Trump presidency. Hopes he may take more pragmatic positions on trade and immigration policy than those he espoused during the campaign may be forlorn. If he were to impose punitive, unilateral, across-the-board tariffs on Chinese and Mexican goods, leading to widespread trade wars, much higher inflation could ensue.
Similarly, if Trump were to follow through on his threat to rapidly deport several million illegal immigrants, the resulting shrinkage in the labour force would be inflationary as well as being negative for growth. In other words, if he were to pursue these policies aggressively there is a risk the US, rather than moving more rapidly towards reflation, could experience ‘stagflation’. While such a scenario is unlikely, political developments will require close monitoring.
The main downside risk appears to emanate from China, where there are growing signs of financial excess and where the government could yet be forced to abandon its growth targets, particularly if Trump were to take aggressive action to curb Chinese exports to the United States.
We believe the risks to be broadly balanced. The likelihood remains that while inflation will pick up it will not get out of control. But much will depend on the forthcoming policy decisions taken in Washington.
As for what this means for financial markets, Giles Parkinson, Global Equity Fund Manager at Aviva Investors, says the general assumptions is that it will be bad for bonds but better for equities. However, he believes the reality is unlikely to be quite so straightforward.
“People have seen the bond market sell off and shifted into ‘cyclical’ shares, assuming there is going to be stronger economic growth. But actually, if bonds have really risen because of worries over inflation, you need to think about individual companies’ pricing power.
“Take a company with strong brands such as Unilever. In the UK it seems to have managed to pass on cost increases, stemming from a decline in the pound, to its supermarket customers. But companies with weaker brands, and producers of own-label products, are likely to struggle to do this,” he says.
Parkinson also cautions that not all companies will be able to preserve cash flows equally well in an inflationary environment. Firms with large amounts of fixed capital investment will suddenly look like they are making more profit than they actually are. As the cost of replacing that capital will rise in an inflationary environment, there will be a tendency for these companies to under-report their depreciation charge.
He also cautioned that much of the better economic news has now been factored in to share prices. “This time a year ago the consensus was for ‘perpetual secular stagnation’. Suddenly the market has started to price in some growth. Exclude commodities, earnings haven’t actually risen by that much. But the amount people are prepared to pay for those earnings has gone up, in some cases spectacularly,” he says.
Meanwhile fixed-income fund managers Orla Garvey and James McAlevey see further strong demand for securities that compensate investors for higher US inflation, such as Treasury Inflation Protected Securities (TIPS).
They say that with headline inflation set to pick up over the next six months thanks to higher energy prices, steadily rising wages and the prospect of US tax cuts, the market will be forced to factor in still higher inflation risk premia.
Noting demand for TIPS has to date mainly come from retail investors and central banks, they say that as inflation picks up even further large institutions such as endowments and pension funds might embark on liability-hedging exercises in greater numbers.
“At a time when the outstanding stock of inflation-protected securities amounts to little more than $1 trillion, supply could prove to be inadequate in the face of greater interest from these large institutions,” Garvey says.
Indeed, the combination of increased demand and the need to factor in higher inflation risk premia means there is a possibility the TIPS market begins to overestimate future levels of inflation.
Equally, they say, it is possible the Fed will suddenly get more hawkish, especially if wage growth accelerates much further. In this event, with interest rates rising faster than expected, the market could actually begin to price in weaker inflation over longer time horizons. They have looked to hedge against this risk elsewhere in their portfolios.
 China National Bureau of Statistics
Unless stated otherwise, any sources and opinions expressed are those of Aviva Investors Global Services Limited (Aviva Investors) as at 17 January 2017. This commentary is not an investment recommendation and should not be viewed as such. They should not be viewed as indicating any guarantee of return from an investment managed by Aviva Investors nor as advice of any nature. Past performance is not a guide to future returns. The value of an investment and any income from it may go down as well as up and the investor may not get back the original amount invested.