Inflation: is that it?



John Pattullo, Co-Head of Strategic Fixed Income, discusses the range of factors, which in his opinion, indicate that current inflation is much more cyclical than structural.

Rising inflation has been a constant drum beat in the markets this year; 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 US), while money supply2 was growing. But, the breakout in inflation never materialised, even though that was the big fear in the markets. In fact, my colleague Jenna 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 Amazonisation of the world are all quite disinflationary.

Why have central banks not been able to generate inflation?
The major central banks have printed almost $12trn 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
Source: Thomson Reuters Datastream, as at 26 October 2018. Please see glossary for definitions.

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 a 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, eg, rising healthcare costs or tariffs. If healthcare 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 analyse 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 legislations 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 Uberisation or  Amazonisation 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 Amazonisation 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 inflation is a measure that excludes the volatile food and energy sector prices. These are included in headline inflation.
  2. Money supply: the total amount of money within an economy.
  3. Output: the amount of something produced by a person, machine, or industry.
  4. Turning 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.
  5. Phillips curve: the Phillips curve represents the long-term relationship between unemployment and inflation in an economy.
  6. Output gap: the difference between the 'potential' national income (output) minus the 'actual' national income in an economy.
  7. Cyclical: referring to the economic cycle; the fluctuations of an economy between expansion (growth) and contraction (recession).

These are the views of the author at the time of publication and may differ from the views of other individuals/teams at Janus Henderson Investors. Any securities, funds, sectors and indices mentioned within this article do not constitute or form part of any offer or solicitation to buy or sell them.

Past performance is not a guide to future performance. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested.

The information in this article does not qualify as an investment recommendation.

For promotional purposes.

Important information

Please read the following important information regarding funds related to this article.

Janus Henderson Horizon Strategic Bond Fund

This document is intended solely for the use of professionals and is not for general public distribution.

The Janus Henderson Horizon Fund (the “Fund”) is a Luxembourg SICAV incorporated on 30 May 1985, managed by Henderson Management S.A. Any investment application will be made solely on the basis of the information contained in the Fund’s prospectus (including all relevant covering documents), which will contain investment restrictions. This document is intended as a summary only and potential investors must read the Fund’s prospectus and key investor information document before investing. A copy of the Fund’s prospectus and key investor information document can be obtained from Henderson Global Investors Limited in its capacity as Investment Manager and Distributor.

Issued in Europe by Janus Henderson Investors. Janus Henderson Investors is the name under which investment products and services are provided by Janus Capital International Limited (reg no. 3594615), Henderson Global Investors Limited (reg. no. 906355), Henderson Investment Funds Limited (reg. no. 2678531), AlphaGen Capital Limited (reg. no. 962757), Henderson Equity Partners Limited (reg. no.2606646), (each registered in England and Wales at 201 Bishopsgate, London EC2M 3AE and regulated by the Financial Conduct Authority) and Henderson Management S.A. (reg no. B22848 at 2 Rue de Bitbourg, L-1273, Luxembourg and regulated by the Commission de Surveillance du Secteur Financier). We may record telephone calls for our mutual protection, to improve customer service and for regulatory record keeping purposes.

Past performance is not a guide to future performance. The performance data does not take into account the commissions and costs incurred on the issue and redemption of units. The value of an investment and the income from it can fall as well as rise and you may not get back the amount originally invested. Tax assumptions and reliefs depend upon an investor’s particular circumstances and may change if those circumstances or the law change. If you invest through a third party provider you are advised to consult them directly as charges, performance and terms and conditions may differ materially.

Nothing in this document is intended to or should be construed as advice. This document is not a recommendation to sell or purchase any investment. It does not form part of any contract for the sale or purchase of any investment.

The Fund is a recognised collective investment scheme for the purpose of promotion into the United Kingdom. Potential investors in the United Kingdom are advised that all, or most, of the protections afforded by the United Kingdom regulatory system will not apply to an investment in the Fund and that compensation will not be available under the United Kingdom Financial Services Compensation Scheme.

Copies of the Fund’s prospectus and key investor information document are available in English, French, German, and Italian. Articles of incorporation, annual and semi-annual reports are available in English. Key Investor document is also available in Spanish. All of these documents can be obtained free of cost from the local offices of Janus Henderson Investors: 201 Bishopsgate, London, EC2M 3AE for UK, Swedish and Scandinavian investors; Via Dante 14, 20121 Milan, Italy, for Italian investors and Roemer Visscherstraat 43-45, 1054 EW Amsterdam, the Netherlands. for Dutch investors; and the Fund’s: Austrian Paying Agent Raiffeisen Bank International AG, Am Stadtpark 9, A-1030 Vienna; French Paying Agent BNP Paribas Securities Services, 3, rue d’Antin, F-75002 Paris; German Information Agent Marcard, Stein & Co, Ballindamm 36, 20095 Hamburg; Belgian Financial Service Provider CACEIS Belgium S.A., Avenue du Port 86 C b320, B-1000 Brussels; Spanish Representative Allfunds Bank S.A. Estafeta, 6 Complejo Plaza de la Fuente, La Moraleja, Alcobendas 28109 Madrid; Singapore Representative Janus Henderson Investors (Singapore) Limited, 138 Market Street, #34-03 / 04 CapitaGreen 048946; or Swiss Representative BNP Paribas Securities Services, Paris, succursale de Zurich, Selnaustrasse 16, 8002 Zurich who are also the Swiss Paying Agent. RBC Investor Services Trust Hong Kong Limited, a subsidiary of the joint venture UK holding company RBC Investor Services Limited, 51/F Central Plaza, 18 Harbour Road, Wanchai, Hong Kong, Tel: +852 2978 5656 is the Fund’s Representative in Hong Kong.

Information on this document is on Janus Henderson Investors’ best endeavours.

Specific risks

  • This fund is designed to be used only as one component in several in a diversified investment portfolio. Investors should consider carefully the proportion of their portfolio invested into this fund.
  • The Fund could lose money if a counterparty with which it trades becomes unwilling or unable to meet its obligations to the Fund.
  • The value of a bond or money market instrument may fall if the financial health of the issuer weakens, or the market believes it may weaken. This risk is greater the lower the credit quality of the bond.
  • Changes in currency exchange rates may cause the value of your investment and any income from it to rise or fall.
  • If the Fund or a specific share class of the Fund seeks to reduce risks (such as exchange rate movements), the measures designed to do so may be ineffective, unavailable or detrimental.
  • When interest rates rise (or fall), the prices of different securities will be affected differently. In particular, bond values generally fall when interest rates rise. This risk is generally greater the longer the maturity of a bond investment.
  • Any security could become hard to value or to sell at a desired time and price, increasing the risk of investment losses.

Risk rating


Important message