March 31, 2018
A Paradigm Shift? Inflation Narrative in Focus
First Quarter 2018 Newsletter
The Return of Volatility – Equities began the year by extending their 2017 gains. But, in late January, accumulating uncertainties and rapidly rising yields eventually pushed equity volatility up and drove prices down. Nearly all major stock and bond categories finished the period in negative territory. Following an unprecedented streak of 19 consecutive months without a 5% correction for the S&P 500, the US equity benchmark fell nearly 10% in just 10 trading days in February. A brief recovery in stocks in the latter part of February was interrupted again in March by concerns over a potential trade war between the US and China.
In March, the Federal Reserve raised rates for a sixth time since the end of 2005. Nevertheless, developed-market sovereign bond yields have remained stubbornly low until recently. As inflation began surfacing in US consumer reports, yields started to climb. The 10-year US Treasury Yield hit 2.95% in March, a level it hasn’t reached in almost 3-years, which followed the original “taper tantrum” sell-off.
Displacing Deflation from Investors’ Mindset – Inflation trends have been declining for the better part of three decades. However, the millennial year marked the flatlining of the core consumer price index. As a result, central bankers have become obsessed with raising the level of inflation beyond the 2% trend rate experienced since the turn of the century. The great financial crisis of 2009 served to intensify the fixation.
High inflation can be harmful to an economy when it is not accompanied by rising wages. Equally, low inflation can hamper corporate pricing power which restrains earnings. Accordingly, the Federal Reserve attempts to boost the long-run growth rate by exercising control over inflation, as it is transparent and linked to the health of the economy. The problem is that inflation cannot be measured by an increase in the price of one product or service, or even several products or services. Rising costs are not spread evenly between businesses and industries, which contributes to the absence of inflation in government data.
Since the early 1980s, inflation has slowed in developed economies for a variety of reasons including demographics, technological advances, M2 money supply declines and higher corporate concentration. Further, given the swath of retirees over the next decade as well as the likely displacement of jobs due to robotics and artificial intelligence, runaway inflation is an unlikely concern in the foreseeable future. It is no wonder inflation fears have become so subdued. As a result, relative to financial assets, hard assets and commodities have only been this cheap twice in the past 50 years – 1970-1972 and 1998- 2000.
So, why are we doubtful about the disregard for an inflation surprise?
- Over the last few quarters, corporate earnings reports have stated concerns about tight labor markets and emerging inflationary pressures. This is a decisive shift from the deflationary tones of 2015 and 2016. Management strategy discussions frequently involve methods to pass on price increases from materials and labour.
- China is contributing to global inflation due to increasing factory prices. Historically, China exported deflationary forces to the world with lower labour costs. Looking forward, the country is also set to deliver on right-sizing industrial capacity in sectors that were previously oversupplied; such as aluminum, coal and steel.
- A wide range of reflation-markets and related-indicators have been breaking from long-term patterns. After declining over 60% from peak-to-trough from 2014 to 2016, oil prices stabilized and are now up over 100% from the January 2016 low. Oil is a key input not only for transportation but also feed stock and plastics.
- On 02-Feb-18, the Bureau of Labor Statistics reported a 2.9% increase in average hourly earnings.
With government data now picking up the inflationary signals, bond yields quickly moved higher causing a bond sell-off. The impact was also felt in equity markets, given the potential shock higher costs would have on corporate profits. As such, investors should remain nimble and cognizant of inflation’s impact on both asset classes.