We examine the inflation outlook in major developed markets and the implication for inflation-related bond markets.
In recent months we have observed continued strong global growth, progress on US tax plans amid a broader fiscal stimulus, and indications that business investment will increase. Coupled with this, commodity prices have also pushed higher. This is all helping to lift headline inflation across the globe but the speed of recovery in underlying inflation varies significantly between different geographies. Accordingly, our portfolio positions vary between markets.
A little discretion
The US is in an advanced stage of recovery and moderate inflation pressures are evident. Higher US rates are a headwind to US inflation but the gradual, well-telegraphed nature of hikes has not placed undue downward pressure on consumer prices. Six-month annualised core US CPI is now a strong 2.6% per annum and above headline CPI at 2.4%. The shorter-term measure is consistent with core personal consumption expenditures (PCE) inflation slightly above the Federal Reserve’s (Fed) 2% target. The increase has been broad-based across non-discretionary inflation items, such as food, medical services, transportation and education services, while shelter inflation has remained strong. Wages are increasing slowly and the trade-weighted US dollar is down over 10% from early 2017. Combined with looser fiscal policy, the potential for tariffs and higher commodity prices, this suggests that the uplift in US inflation can be sustained for now.
However, we do have lingering concerns regarding the longevity of this uplift on a longer horizon, in the absence of major shocks, such as a trade war. The inflationary pressures outlined above are, to some extent, either prescriptive in nature, whereby consumers have little choice but to pay the higher prices, or are the results of a depreciating US dollar which have a transitory impact. The lack of participation from most discretionary inflation items, such as furniture, vehicles and recreation, is acting as a drag on the headline number and is particularly concerning in the context of a steadily declining savings rate among US consumers. This can be observed in Chart 1 where discretionary inflation has been around zero for several years now. It is likely that technological drivers play a role here alongside the very long-term drivers of globalisation and demographics, potentially limiting the extent of future increases in US inflation.
Market pricing has returned to the levels observed in the aftermath of the 2016 election. Breakeven yields have risen as macroeconomic improvements have outweighed the drag on inflation from tighter monetary policy. The 5-year forward 5-year inflation swap rate of 2.4% is consistent with the Fed attaining its core PCE target, but levels are below their historic average and very little term premium is factored into the inflation swap curve. We are therefore long US inflation in portfolios.
In Europe the landscape is different. The European Central Bank (ECB) is transitioning between quantitative easing and tapering, but rate hikes are not anticipated imminently. Growth is strong and inflation is expected to rise but at a fairly slow pace. Core inflation is still only around the 1% level and has printed in a range of 0.6% to 1.2% per annum since April 2013. We do not envisage a sudden breakout to the upside despite the better-than-anticipated growth data and apparent optimism surrounding the region.
High unemployment and labour market slack are important for the inflation outlook in Europe. The IG Metall and public sector pay settlements are being seen as evidence that wage growth is materialising. However, we are not of that opinion: corporate desire to maintain competitiveness by keeping labour costs low and the ease of moving production to Central and Eastern European countries puts downward pressure on wage demands from labour unions. The recent oil price move will be supportive for European inflation but euro appreciation broadly offsets this. The ECB has made reference to the influence a stronger currency potentially has on the macroeconomic environment and our opinion is that continued strength may have some bearing on its policy outlook.
All in all, markets are pricing in inflation to return to ‘close to but below 2%’ over the medium term. The long end of the market is pricing in above target inflation, and therefore we are positioned short in portfolios.
Britain is an island
In the UK the story is different again. Data have held up relatively well and the Bank of England revised up its growth forecasts in February although potential growth is still viewed to be just 1.5% per annum. UK inflation has been elevated but has now started to turn down as past currency effects, which have driven goods prices up with little impact on services, are starting to fade. Despite the recent downward path for UK inflation, the Bank of England Monetary Policy Committee has focused on the positive data as the justification for tighter policy, while recognising that as the implications of Brexit become clearer, it will need to be pragmatic in its approach. On the basis of its current policy stance, however, we believe higher rates are likely to lead inflation back to target sooner rather than later. We view UK inflation as optimistically priced given we expect it to decline sharply as past currency effects fade, and as such, we are positioned short in portfolios.
The overall picture is one of inflation rising (except in the UK) at different speeds across the globe but nowhere so fast that policy will need to adjust rapidly. We still see value in US inflation relative to Europe given recent momentum and currency movements.