There was a violent market reaction to the recent wage data from the US as investors were spooked by the prospect of an inflation shock. We think that investors have been reading too much into this single, and notoriously noisy measure. Nonetheless, looking at broader measures we have been positioning for normalised inflation since the end of last year. Here we expand on our thinking in this area.
Fire has a lot in common with inflation. The control of fire has been the most important development in human history. It helps to keep us warm as well as allowing us to cook food and keep danger at bay. In many ways, inflation is to markets as fire is to man: too little and markets suffer in the freeze of deflation, too much and it risks becoming out of control and burning the whole place down.
Inflation (or price stability) is very important to the orderly functioning of markets and economies. Major institutions (Central banks) all over the world have an implicit or explicit mandate to control it at a level typically around 2% per annum in developed markets. Central banks, in turn, need to anticipate inflation and change interest rates ahead of any evident inflation problem to accommodate the significant lag between monetary policy action and its effect. This is the main reason that markets have been reacting strongly to any hint of looming inflationary pressures, such as a strong US wage print.
We believe that we are at an inflection point for inflation, but the case is relatively nuanced. In this article, we take a closer look at some of the central aspects of our thinking in this area, and how this is influencing our investment strategy.
There are myriad different ways to define and measure inflation, with the US Federal Reserve preferring the Personal Consumption Expenditure (PCE) index whilst most people are probably more familiar with Consumer Prices Index (CPI). There are also ‘core’ inflation variants that strip out the more volatile elements such as energy and food prices to create a more stable measure of underlying price inflation.
If you’re a Central bank or an investor, the trends in underlying price pressures are more critical than any short-term effects. One-off effects, such as a sharp currency move, commodity price spike or sales tax hike will move out of the record period after a year (base effect), and are little affected by monetary policy anyway. Conversely, inflation driven by an overheating economy can accelerate over time and feedback on itself, requiring Central bank intervention. As a result, it is the latter that we are most focused on, whereas it’s the former that tends to grab news headlines.
As we covered above, any factors that are only temporary should be given consideration but ultimately they are usually discounted from the investment outlook. Their longer-term effects tend to be negligible in terms of monetary policy, despite potentially sizeable short-term impacts. There are many examples of such transitory effects, such as the Japanese sales tax hike in 2014 which caused an almost immediate additional 2% surge in the inflation reading. Another was the change last year in US mobile phone data charging which has caused disinflationary pressures over the last 12 months.
Here in the UK, the most obvious and frequently-cited transitory effect is the Brexit-related depreciation of sterling. This saw the pound fall 10% from its pre-referendum level (and where it broadly remains at the time of writing), and by up to 20% from its 2015 peak to 2016 trough, all on a trade-weighted basis. As a result, the costs of imports (including business input costs) rose, driving inflationary pressures.
Such effects are likely to be transitory, but the timing is harder to discern, given the pass-through to the final numbers can be somewhat extended. For example, many companies will have locked in their costs in advance or may be prepared to absorb higher costs for a period of time. We can see this in the UK Producer Prices Index (PPI, below) which shows how much more (or less) UK manufacturers are paying for input materials and also the change in price of the final produced goods – so-called factory-gate prices.
Input costs have now dissipated after peaking in early 2017, and we see the pass-through leading to marginally higher factory-gate prices. We also see similarly elevated pass-through prices on related measures, including those prices implied by retail sales (particularly in the most import-sensitive areas, such as clothing and footwear) and in surveys such as the Purchasing Managers Index.
On balance, it seems reasonable to expect that headline UK inflation figures will start trending down over the next 12 months. This closely aligns with various measures of market expectations, where indicators such as gilt-derived breakevens and forward inflation swaps show that the market expects inflation to average closer to the 2% target for the medium and long term.
The risk, then, is not that inflation remains at the currently high levels, driven by isolated factors, but that underlying inflation puts pressure on the inflation rate after these factors have transited.
At first glance, it might seem like the US and UK have opposite problems, with UK core inflation well above target and US core inflation below target (see chart below). In reality, both the US Federal Reserve and the Bank of England need to address tomorrow’s problems today. Looking at inflation rates today, there seems very little to worry about – inflation is still soft in the US and we are confident it will drop in the UK. But today’s monetary policy will impact core inflation in the future and must be set now to avoid both excessive inflation and the risk of stalled economic growth.
We have been in something of a goldilocks period for markets and economies. Company earnings growth has been strong, GDP growth has been reasonable and inflation has been benign – allowing monetary policy to remain very supportive, and in turn letting equities and bonds fly. The concern now is that inflation is back, and Central banks need to avoid being caught napping.
The most obvious cause of sustained, problematic inflation is likely to be wages. Strong wage growth is obviously good for individuals but can be inflationary if disposable income increases faster than the supply of goods. Consumer price inflation (P) from higher wages comes through the velocity (V) and arguably the supply* of money (M) increasing, and the quantity (Q) being static (driven by the equilibrium of Money Supply x Velocity = Price x Quantity or MV = PQ).
Much of the recent discussion has focused on the Phillips curve. It plots unemployment against inflation, which suggests that historically, and subject to certain constraints, low unemployment has correlated with higher inflation. The idea is simply an extension of supply and demand – when supply of labour is scarce (unemployment is low) the price increases (wages rise) as employers have to pay more to hire and retain staff in a competitive environment.
However, thus far in the US, the major developed economy furthest along in the economic growth cycle, wages and inflation appear to have failed to take off even as unemployment has dropped to very low levels. This perhaps explains the sharp movements following the January data release from the Bureau for Labor Statistics, which showed an uptick in its regular establishment-level measure of average hourly earnings (see below) to 2.9% year on year, the highest post-financial crisis reading.
We think this shattering of the market complacency and re-evaluation of the inflation outlook was right, but for the wrong reasons. The most closely watched measure of average hourly earnings in the US is released along with the Non-Farm Payrolls data, but can be rather unreliable in the short term and subject to significant revisions. The establishment-level survey methodology infers average earnings by comparing the total payroll to the total hours worked in a given establishment. However, this can leave it susceptible to demographic bias. For example, as older workers (who tend to be higher paid) leave the work force they are often replaced by younger workers starting at a lower wage, which would suppress the wages reading. The reading is also frequently subject to revisions, which can be relatively substantial.
Digging beneath the surface and using a wider range of measures, the case for tightening labour conditions and higher wages appears more compelling to us. The Atlanta Federal Reserve offers a useful alternative measure based on a household survey that tracks how individuals’ hourly wages have increased over a 12-month period, thereby mitigating some of the demographic biases in the establishment data. As the chart above shows, by this measure wage growth has been more robust, especially in the ‘prime-age’ cohort of workers aged 25-54 that are considered to be the most productive.
We also look to survey data from the National Federation of Independent Business that shows 24% of small businesses plan to increase their worker compensation (the highest since 2000), whilst almost half (49%) are finding few or no qualified applicants – which is actually 89% of those with vacancies to fill (see chart below).
Investor inflation expectations going into 2018 were overly complacent, especially given the signals coming from measures beyond the headline readings. Our base case has been that inflation will normalise in 2018 with some risk to the upside in the second half of the year, especially given the potential for populist fiscal stimulus policies in parts of the world. At this stage, we do not believe a normalised inflation and monetary policy outlook poses a major risk to equities. We have kept our core sovereign bond exposure, which is susceptible to rising inflation, low in terms of weight and duration and late last year we added some inflation-linked bonds to our strategy for certain mandates as appropriate.
Whilst we believe inflation will normalise towards its target in the US and UK, there remain several risks to this view. Productivity gains could offset higher wages (increasing Quantity rather than Price in MV=PQ), companies may be unwilling to increase wages in order to maintain profit margins, or Central banks might overreact and choke off global growth altogether. These risks are not in our base case, but we remain alert to them.
At the end of last year, we argued that markets had become complacent and the withdrawal of ultra-loose monetary policy would likely lead to higher volatility. The recent correction has been uncomfortable in the short term, but is ultimately a healthy development supporting the appropriate pricing of risk. Recent events remain broadly in line with our investment strategy, and we will continue to keep you updated on our latest thinking as the investment landscape develops.
You shouldn’t play with fire, but no one has been burned just yet.
*In terms of consumers’ disposable incomes for consumer goods, in isolation. There is no impact on overall money supply in the broad financial system.
This document is solely for information purposes and is not intended to be, and should not be construed as investment advice. Whilst considerable care has been taken to ensure the information contained within this commentary is accurate and up-to-date, no warranty is given as to the accuracy or completeness of any information and no liability is accepted for any errors or omissions in such information or any action taken on the basis of this information. The opinions expressed are made in good faith, but are subject to change without notice.