We have been watchful for the return of inflation for some time now, with a healthy scepticism about the “lower for longer …forever” mantra. That widely accepted viewpoint is now being questioned as the evidence builds that the days of disinflation are behind us. Inflation is beginning to come through in developed economies and bond markets have been quick to notice it.
Lower for longer – no longer
Deflationary forces have been significant in the global economy over the last decade but these are now on the wane, indeed even reversing in some cases. The bargaining position of labour (the ability of workers to negotiate better terms of employment/higher pay) has been weak for many years. This has resulted in widening income inequality, which has manifested itself in the changing political landscape. In the West, we have already seen the backlash against the political establishment through the rise of populism. Voters (ie. workers) have had enough. This coincides with a tightening in labour markets, with falling unemployment making it more difficult for firms to recruit workers, which tends to push up wages.
In the US, wage inflation is already on the rise, see chart 1, while here in the UK, employment is at record levels. Economies are close to full employment, a situation where anyone who is able and willing to work is employed. And this is before the squeeze on immigration comes into play, following Donald Trump’s election and Brexit. Add in demographic shifts as the number of retirees rises relative to the number of people actively in work and the stage is set for persistent wage inflation after many lean years.
Chart 1: US wage inflation is increasing
Source: Thomson Reuters Datastream, as at November 2016. Shows 12-month percentage chance in average hourly earnings (total private non-farm payrolls).
The making of Trumpflation
Another key disinflationary pressure has been globalisation; free trade has increased the volume and variety of goods available, but has also suppressed prices. Chart 2 shows the impact on the price of food and drinks in the UK. We in the West have benefitted as consumers, but have lost out as wage earners. China has been exporting deflation to the world by devaluing its currency, although this is changing as the supply of cheap migrant labour to the country’s cities slows. Wages have soared in China, and debt, which has subsidised the increase in production capacity, has ballooned. Trump’s proposed protectionist policies in the US are a reaction to China’s actions, but putting restrictions on trade and adding import tariffs adds to inflationary pressures. These pressures would be compounded by Trump’s negative stance on immigration and plans to lower taxes and increase spending. Hence “Trumpflation” enters the lexicon.
Chart 2: Falling food prices have weighed on inflation
Source: Thomson Reuters Datastream, as at December 2016. Food & beverage contribution to CPI inflation.
What about Brexit?
In the UK, Brexit – be it ‘soft’ or ‘hard’ – is likely to have similar trade-related inflationary effects. Add to that the impact of sterling’s devaluation, which plunged dramatically following the Brexit vote, and imported inflation should reach the high street (or out-of-town shopping centres these days) as cost increases are passed to consumers. Marmite and Toblerone have been in the headlines already on that subject. While this should have a more transitory impact, higher headline inflation figures will bolster wage negotiations.
Chart 3: Medium-term inflation expectations above MPC’s 2% target
Source: Thomson Reuters Datastream, as at 9 December 2016. Chart shows the UK 5-year/5-year inflation swap rate. Used as an indicator of medium-term inflation. The MPC is the Bank of England’s Monetary Policy Committee and is responsible for setting interest rates, with the aim of keeping inflation at – or close to – their current target of 2%.
Markets are reflecting these changes. Bond markets are selling off and forecasts suggest a belief that higher inflation will come through over the next few years, as chart 3 shows. Yield curves are steepening, indicating the expectation of high interest rates, and index-linked bonds, which can provide some protection from inflation, have benefited from strong investor interest. Central banks have subtly changed their tune; they are now willing to accommodate or even encourage inflation. We see these trends continuing as inflation moves from its current very low base; ‘normalisation’ still has some way to go.
In terms of what the return of inflation means for the fund, the bond portfolio can be protected to some degree by keeping low duration and holding index-linked bonds. The latter currently represents a third of the fixed income portfolio. We also continue to hold a relatively large exposure to UK equities – an area of the market that might be expected to benefit as investors switch from bonds. Higher inflation should also increase nominal returns (the total rate of return, including inflation), although this is a debatable point. We must accept that there may be negative consequences for stock prices if inflation is seen to be dangerously high.
We are invested in a number of domestic sectors which should perform relatively well if inflation does indeed pick up as expected, including travel and leisure, retail, banks, insurance and support services. Banks, for example, would be expected to benefit from rising inflation via higher rates on lending, while retailers are generally able to pass on higher costs to consumers – up to a point. In our view, bank note printer De La Rue, currently in the portfolio, should be one of the more obvious beneficiaries from higher inflation.
Deflation: A decrease in the price of goods and services across the economy, usually indicating that the economy is weakening (negative inflation).
Disinflation: A term used to describe when the rate of inflation falls.
Duration: How far a fixed income security or portfolio is sensitive to a change in interest rates. It is expressed as a number of years. The larger the figure, the more sensitive it is to a movement in interest rates.
Index-linked bonds: Bonds where the interest payments and loan repayment amount are adjusted in line with the rate of inflation. For example, Treasury Inflation Protected Securities (TIPS), issued by the US government. Index-linked bonds, or ‘linkers’, are also known as inflation-linked bonds.
Inflation: The rate at which the price for goods and services is increasing in an economy. The Consumer Price Index (CPI) and Retail Price Index (RPI) are two commonly used indicators.
Price/earnings (P/E) ratio: A popular ratio used to value a company’s shares. It is calculated by dividing the current share price by its earnings per share. In general, a high P/E ratio indicates that investors expect strong earnings growth in the future, although a (temporary) collapse in earnings can also lead to a high P/E ratio.
Yield curve: A graph that plots the yields of similar quality bonds against their maturities (the date at which the money owed to the lender is repayed). In a normal/upward sloping yield curve, longer maturity bond yields are higher than short-term bond yields. Changes to the yield curve as commonly used as an indicator of changes in economic output and growth.