The period since the GFC has been characterised by very low inflation (and interest rates) and, investors’ portfolios have responded to this with an ever increasing reach for yield. However, is the inflation outlook at an inflection point?
Low inflation has been built on four foundations:
Excess capacity following the GFC, particularly in labour markets
Globalisation
Exported deflation from China
Excess debt and debt deflation
But three out of four of these foundations are starting to break down:
Labour market slack is much lower. While the rebound from the recession of 2008 has been slower than most – this was almost a decade ago. Modest employment growth as well as the impact of demographics on the size of the labour force has seen unemployment fall. For example, see below for the US.
Globalisation is under threat with increased protectionist sentiments in many countries. The most glaring example of this are the recently announced steel tariffs in the US (and response from China with retaliatory measures of their own). Protectionism is inherently inflationary (the whole point is to push up prices for domestic producers).
China is no longer exporting deflation to the rest of the world. Chinese producer prices are rising. There has been a shift in government policy on two fronts.
The environment and pollution are a much higher priority in China than a decade ago. The Chinese government is making substantial efforts to reduce pollution in China (and is under material pressure from its population to do so). This will push up costs and prices. It will also rapidly reduce excess capacity in highly polluting industries.
China’s attitude to debt and capital allocation. Part of what has made the “equilibrium” of economic growth of the last few years work is China’s willingness to continue to make large debt funded investments in capital goods and capacity even when those investments have low returns on capital. This has propped up aggregate demand on a global basis – but at the cost of ever more debt on the Chinese balance sheet. There are increasing signs that the Chinese government is concerned about the risks from its prodigious debt build up and, going forward, will not be willing to be the low return investor. This will reduce excess capacity and, combined with the costs of better environmental performance, see China shift from exporting deflation to potentially exporting inflation. See below for PPI trends in China.
The one deflationary factor that has not disappeared is debt. Debt levels have continued to grow and the recently passed tax changes in the US will see the US run a very large budget deficit for the next few years (particularly for this stage of the economic cycle). At present, concerns about debt sustainability – which were acute during and in the immediate aftermath of the GFC – have abated. Whether markets retain their current sanguine view of debt sustainability as interest rates rise (see below) remains an open question.
What does a shift to higher inflation mean?
It means higher interest rates – both at the long end as bond investors demand higher yields to protect against inflation – as well as at the short end as central banks act to tighten monetary policy from its incredibly stimulatory levels.
It means central banks have less room to respond to financial market weakness. That is, perhaps the end (or at least the reduction) of the Greenspan/Bernanke/Yellen put. Certainly, if central banks had a choice between a bit of financial market weakness now (when the underlying real economy in the US is benefiting from a trifecta of hurricane rebuilding activity, massive tax cuts and potentially an infrastructure building program) and a year or two from now (when these temporary stimuli will have passed) they would most certainly choose now.
It means lower valuations for assets – higher base rates will put downward pressure on equity valuations as well as the bond substitutes such as infrastructure and property. Our view is that credit spreads are likely to move wider – on the back of a reversal of the liquidity and market dynamics that have driven the hunt for yield. If low interest rates and the There is No Other Alternative mindset have driven yields and spreads down over the past decade – then presumably higher rates, higher volatility and lower liquidity (as quantitative easing turns to quantitative tightening) operates in reverse.
All this says inflation will be a key focus of financial markets for the months ahead.