Today’s CIO Weekly Perspectives comes from guest contributors Ashok Bhatia and Olumide Owolabi.
Inflation rates consistently below or around target levels since the global financial crisis have changed investors’ expectations for, and pricing of, forward inflation. The level of investor concern about persistently low inflation only increases with every below-target inflation report.
The most recent downtrend in inflation has led investors, and even some on the Federal Reserve Board, to pronounce dead the Phillips curve relationship between the unemployment rate and wage growth.
The current inflation dynamics do look puzzling. Despite strong above-trend economic growth, a tight labor sector and gradually increasing wage growth, core inflation levels in the U.S. have declined. However, a careful analysis of inflation trends highlights that a few powerful factors drove low inflation dynamics over the past two decades, and these factors are beginning to show signs of reverting back to their longer-term structural relationships.
In the short to medium term, we anticipate that underlying inflation will trend gradually from the current, very low levels toward target levels of around 2%.
Why do we believe this? First, globalization—which has been a key driver of low inflation rates as low wage markets have integrated into the global trading system—seems to have peaked. Producers and multinationals will likely be forced to rebuild supply chains, leading to higher production and labor costs that will eventually get passed on to consumers. Also, governments that were previously reluctant to provide fiscal stimulus could soften their stance to support local businesses as they navigate these supply-chain transitions in the various economies.
Second, we anticipate continued strong demand-side dynamics. Household balance sheets are strong and we anticipate continued, if not pent-up, demand in spending on discretionary goods.
Third, and probably most powerful, is the potential for a switch in inflation framework by global central banks. Acknowledging a problem is the first step to solving it, as the saying goes, and leaders on the Federal Reserve Open Markets Committee and at the European Central Bank have openly acknowledged the limitation of targeting a specific level of inflation recently. That leads us to believe that an attempt to change the inflation framework in those institutions is the works. If effected and communicated well, this change has the potential to shift investors’ inflation expectations higher.
Finally, and perhaps a bit more tactically, we think U.S. inflation rates have been pushed temporarily lower this year by one-off factors, such as the financial services sector price changes observed in PCE inflation, which tracks portfolio management advisory fees and financial services commissions. The sector’s recent drop-off in its contribution to overall inflation was largely attributable to the weakness in financial assets during the fourth quarter of 2018. Given the rebound in risky assets since start of the year, and the strong historical correlation of the sector with financial market performance, we anticipate a reversal of prior weakness.
Insufficient Risk Premium
Considering the above, we think U.S. Treasury Inflation-Protected Securities (TIPS)—securities issued by the U.S. government that provide inflation protection by having their principal and interest payments linked to the Consumer Price Index—offer potential long-term value. We believe this view is supported by investors being biased by the low inflation of the current business cycle, the current positive fundamental economic backdrop, and the potential for an adjustment to the inflation framework by central banks.
In the near term, TIPS prices seem to reflect an insufficient risk premium, considering that the U.S. Fed has tilted dovish and has now engaged in “insurance” rate cuts to support and extend the business cycle. From a technical standpoint, we anticipate that the asset class will continue to be well supported. Investment managers have filled the gap vacated by decreased foreign investor sponsorship so far this year. In addition, the Fed has signaled that it will be a natural buyer by announcing that it will allocate around 8% of the expected reinvestment of agency debt and mortgage-backed securities principal payments to TIPS as part of its activities to end balance sheet normalization.
In Case You Missed It
- U.S. Personal Income and Outlays: Personal spending increased 0.3%, income increased 0.4%, and the savings rate increased to 8.1% in June
- S&P Case-Shiller 20-City Home Price Index: May home prices increased 0.6% month-over-month and 2.4% year-over-year (NSA); +0.1% month-over-month (SA)
- U.S. Consumer Confidence: +11.4 to 135.7 in July
- Euro Zone 2Q 2019 GDP (First Estimate): +1.1% annualized rate
- Euro Zone Consumer Price Index: +1.1% year-over-year in July
- FOMC Meeting: The FOMC reduced the fed funds rate to a range of 2.0 – 2.25%
- China Purchasing Managers’ Index: +0.5 to 49.9 in July
- Japan Purchasing Managers’ Index: -0.2 to 49.4 in July
- ISM Manufacturing Index: -0.5 to 51.2 in July
- U.S. Employment Report: Nonfarm payrolls increased 164,000 and the unemployment rate was unchanged at 3.7% in July
What to Watch For
- Monday, 8/5:
- ISM Non-Manufacturing Index
- Friday, 8/9:
- China Consumer Price Index
- U.S. Producer Price Index
Statistics on the Current State of the Market – as of August 2, 2019
|S&P 500 Index||-3.1%||-1.6%||18.3%|
|Russell 1000 Index||-3.1%||-1.7%||18.6%|
|Russell 1000 Growth Index||-3.3%||-1.6%||22.3%|
|Russell 1000 Value Index||-3.0%||-1.8%||15.1%|
|Russell 2000 Index||-2.8%||-2.6%||14.6%|
|MSCI World Index||-2.9%||-1.7%||16.0%|
|MSCI EAFE Index||-2.6%||-1.8%||11.1%|
|MSCI Emerging Markets Index||-4.2%||-3.2%||6.0%|
|STOXX Europe 600||-3.4%||-2.3%||11.2%|
|FTSE 100 Index||-1.9%||-2.4%||12.9%|
|CSI 300 Index||-2.8%||-2.3%||26.9%|
|Fixed Income & Currency|
|Citigroup 2-Year Treasury Index||0.3%||0.3%||2.6%|
|Citigroup 10-Year Treasury Index||2.0%||1.5%||9.0%|
|Bloomberg Barclays Municipal Bond Index||0.5%||0.4%||6.4%|
|Bloomberg Barclays US Aggregate Bond Index||1.0%||0.7%||7.1%|
|Bloomberg Barclays Global Aggregate Index||0.8%||0.6%||5.9%|
|S&P/LSTA U.S. Leveraged Loan 100 Index||0.1%||0.0%||7.9%|
|ICE BofA Merrill Lynch U.S. High Yield Index||-0.4%||-0.4%||10.3%|
|ICE BofA Merrill Lynch Global High Yield Index||-0.3%||-0.4%||9.4%|
|JP Morgan EMBI Global Diversified Index||0.0%||0.0%||12.6%|
|JP Morgan GBI-EM Global Diversified Index||-1.5%||-1.6%||8.0%|
|U.S. Dollar per British Pounds||-2.2%||-1.0%||-4.8%|
|U.S. Dollar per Euro||-0.2%||-0.3%||-2.9%|
|U.S. Dollar per Japanese Yen||2.0%||1.9%||3.0%|
|Real & Alternative Assets|
|Alerian MLP Index||-3.2%||-1.8%||14.6%|
|FTSE EPRA/NAREIT North America Index||0.5%||0.1%||18.8%|
|FTSE EPRA/NAREIT Global Index||-0.7%||-0.2%||15.3%|
|Bloomberg Commodity Index||-1.9%||-2.2%||2.1%|
|Gold (NYM $/ozt) Continuous Future||2.7%||1.4%||13.8%|
|Crude Oil (NYM $/bbl) Continuous Future||-1.0%||-5.0%||22.6%|
Source: FactSet, Neuberger Berman.