January 2019

Inflation – Is That It?

Strategic Fixed Income

John Pattullo, Co-Head of Strategic Fixed Income, discusses the range of factors that he believes indicate that current inflation is more cyclical than structural.

Key Takeaways

  • The hype on inflation continues to impact the markets, yet the Strategic Fixed Income Team believes a structural breakout is unlikely in the near future; if anything, they see a greater likelihood of inflation falling.
  • If there were to be a structural breakout in inflation, they believe 2018 had the perfect ingredients for it.
  • Still, policymakers are hampered in the task of bringing inflation back to target levels by their strict adherence to old, traditional economics.

Rising inflation has been a constant drum beat in the markets. Should it be at the forefront of investors’ thinking moving into 2019?

2018 was really a reflationary1 year, driven by the Chinese expansion that began a couple of years ago, President Trump’s tax cuts, strong equity markets and strong economic activity (mainly in the U.S.) while money supply2 was growing. But the breakout in inflation never materialized, even though that was the big fear in the markets. In fact, my colleague and Co-Head of Strategic Fixed Income Jenna Barnard, CFA, recorded a video in February talking about the hysteria of inflation. Inflation expectations did rise a little in the following months but peaked in May and have subsequently fallen markedly. We think expectations will fall further going forward, not least because of the recent oil price plunge.

The way we see the world is very much one of secular stagnation, as there is not enough growth and demand in the world to purchase “output”3. We think there is plenty of output capacity to fill the current demand, but this demand is generally a lot lower than it has been in previous economic cycles. In addition, we think that the world is turning quite Japanese4 – there is too much debt in the world, technology is eroding pricing power and the effects of Amazon and the “Amazonization” of the world are all quite disinflationary.

Why have central banks not been able to generate inflation?

The major central banks have printed almost $12 trillion of quantitative easing (QE), but we have not had any core consumer price inflation. We have, of course, had asset price inflation, and that has been quite inequitable for many concerned.

Core Inflation Remains Stubbornly Low

G7 Core and Headline Inflation

Core Inflation Remains Stubbornly Low Chart | Janus Henderson Investors

Source: Thomson Reuters Datastream, as of October 26, 2018.

I believe a lot of policymakers are confused about the puzzle of inflation. They do not really understand why inflation has not broken out. I think the problem is they are using the wrong set of economic textbooks. They are using very conventional economics, which looks at the Phillips curve5 relationship and output gaps6 – assuming that there is one person, working in one factory, making one tangible product – and that is not really the world we live in any longer. We live in a gig economy, a transparent world. Most of us work in service industries, in a very global economy without trade unions and not making tangible products. For example, if you are a computer games manufacturer, you could invent a game on your computer and sell 10 or 10 million. You could even sell 100 million, but you would not be capacity constrained.

All these things would suggest that conventional economics does not really give a good explanation for the puzzle of why we do not have higher inflation.

Are there different types of inflation?

We believe that what we have seen is cyclical7 inflation. There has been an uptick in activity and a small uptick in inflation, which is no surprise to us. But we have not seen a structural uptick in inflation or inflation expectations. Further, inflation expectations have not changed. Markets do not believe that central banks can achieve permanently higher inflation. This is primarily because there is not enough demand in the economy to push up prices. And that’s called demand pull inflation.

Generally, demand-pull inflation is where there is too much demand for the amount of economic output, so invariably prices would be pulled up. We do not currently see evidence of this; if anything, there is too much capacity and too much transparency for companies to be able to raise prices. In such an environment, significant inflation would be expected, but this is not reflective of the world as we currently see it.

The other sort of inflation is cost push inflation. And I think some commentators get a little bit confused here. Cost-push inflation is the inflation that goes up because the cost of things rises. Typically it might be through wages, the oil price, the depreciation of, say, sterling in the UK, or other countries with falling currencies making it more costly to import goods. Or indeed it might be tax like inflation, e.g., rising health care costs or tariffs. If health care costs increase, the consumer is essentially hit with an additional tax and subsequently has less cash in their pocket, while tariffs can also reduce the cash in the consumer’s pocket.

So in summary, yes there are different types of inflation, and it is important to analyze the drivers.

So what is behind the inflation that we already have?

There has clearly been some wage inflation. Especially in America, higher levels of employment have contributed to the resurgence of some wage pressures. In addition, the minimum wage legislation in the UK and in some states in America has made hiring workers more costly. However, the key point is that this extra cost in wages is not getting pushed onto “final cost” or “goods price” inflation.

The traditional model would suggest that if there is a shortage of workers, companies will have to pay them more. If they are paid more, this will be reflected in a rise in the cost of the product being sold. But with the transparency of the internet, the Uberization or Amazonization of the world as we sometimes refer to it, it is very hard to put the input cost straight onto the output cost. This is due to the current high levels of competition and the plentiful capacity globally to make whatever is required.

So we believe at the moment the missing link is modest wage inflation not getting pushed into output price inflation or goods price inflation.

Where do you see inflation heading in the future?

There are a whole host of factors that would suggest inflation, in our opinion, is much more cyclical. We do not expect any structural breakout and even if this were likely, 2018 was the pivotal year for it to happen. If anything, we are now more concerned about inflation falling away. Headline inflation will certainly ebb with the weak oil price, and core inflation will likely remain fairly muted in line with the trend of recent years.

Since mid-2017, we have been consistent in our messaging about the late cycle nature of the economy and the markets. However, the long-term secular drivers that we have also spoken about, such as demographics, debt trap, Japanification and Amazonization, are still in place, and a return to the norm will be much lower growth and lower inflation going forward.

Against this backdrop, the current high levels of market bearishness on government bonds, not helped by false narratives on inflation and the future path of government bond yields, is in our opinion overdone. While the situation varies by country, geography and the actions of the respective central banks, we believe government bonds could present attractive opportunities going forward. If we are right and it is late cycle, this is likely to be the next asset class to logically perform well on a relative basis.

1 Reflation (in simple terms) refers to a return of inflation. Inflation is the rate at which the prices of goods and services are rising in an economy. Consumer price index (CPI), personal consumption expenditures (PCE) and producer price index (PPI) are a few common measures. Core inflationis a measure that excludes the volatile food and energy sector prices. These are included in headline inflation.
2Money supply: the total amount of money within an economy.
3Output: the amount of something produced by a person, machine, or industry.
4Turning Japanese/Japanification: mimicking Japan’s experience where poor demographics and the legacy of a debt crisis led to a long period of sluggish growth and low inflation (and even deflation) in the country.
5Phillips curve: the Phillips curve represents the long-term relationship between unemployment and inflation in an economy.
6Output Gap: the difference between the “potential” national income (output) minus the “actual” national income in an economy.
7Cyclical: referring to the economic cycle; the fluctuations of an economy between expansion (growth) and contraction (recession).

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