- In the last few years, global central banks have been concentrating on avoiding deflation rather than restraining inflation.
- The US presidential election result has shifted that focus back to worries about potential reflation.
- Western Asset continues to assert that inflationary pressures are benign and central banks should embrace the recent rise in inflation.
- A closer examination of the inflation measurement components—and expectations—demonstrates why we believe the recent inflationary pressures are merely transitory.
- In the current environment, Western Asset has become selective regarding inflation-linked bonds, preferring European issues.
- Western Asset views the current benign inflationary backdrop as supportive of credit and risk assets.
The path of global inflation is rightly never far from the minds of monetary policymakers and investors. Until recently, however, the global central banks’ emphasis has been upon avoiding deflation rather than restraining inflation.
Last year’s US election result changed this, fostering a fiscally led reflation theme. Global inflation expectations and breakeven inflation spreads rallied into March. At Western Asset, we remained unconvinced. In this note, Richard Booth explains some of the tools we employ to navigate these trends, and explains why we’re convinced that the market’s recent concern over rising inflation is low on our list of concerns.
- Western Asset has long held the belief that inflationary pressures are benign and central banks should actually be relieved about the recent upward move in inflation (Exhibit 1).
- The dominant driver of the recent up-move in inflation is energy base effects, while the more positive tone from core goods and services percolates in the background. There is ample time to see if this develops or fades as it has many times before.
- Should core goods pricing continue to strengthen and service prices remain firm, we could see an impact on policy later in 2017.
- As such, we’ve become tactical regarding inflation-linked bonds, preferring European if any at all, and see the benign inflationary backdrop as supportive of credit and risk assets.
Building Blocks – Dissecting Inflation Into Manageable Portions
In this note, we describe some of the tools we use to discern the future path of global inflation rates. Many of these amount to “useful rules of thumb,” which we build into forward-looking indicators that have served us well in the past.
When looking at individual country inflation rates, it is useful to split them up into three main blocks:
- Core goods prices, driven by global trends
- Core services, domestically driven and least volatile
- Energy and food prices, most volatile and least predictable
Our goal is to find forward-looking indicators that provide clues as to where these three inflation blocks are heading in the next six to 12 months. We then use indicators to frame our view on global inflation rates.
1. Core Goods Prices
Within the core goods segment of the inflation basket, we focus upon clothes, autos, TVs and IT products. These products are traded throughout the world, and their prices are influenced by the low-cost producers, particularly in China. Therefore, we’d expect the Chinese Producer Price Index (PPI) and Chinese domestic input prices to give a good six-month lead on where global core inflation could be heading.
In Exhibit 2, we can see we are part way through the current cycle, with China’s PPI rate bottoming at - 5.9% year-over-year (YoY) in early 2016 and recovering to the current pace of +7.8% YoY in February 2017. This uplift in Chinese price pressures has led, with a short lag, to the rise in core goods prices in the developed world. We demonstrate this using a simple average of core goods prices in the US, Europe, Japan and the UK.
Foreign exchange rates also come into play. We observe that those with a weaker exchange rate versus the Chinese currency (CNY) (e.g., Europe, Japan, the UK) will see a higher pass-through, while those with a stronger exchange rate (e.g., the US) will see a smaller a pass-through. This may explain why we observe weakness in core goods prices in the US, while they are still rising/accelerating in the other economies.
So where are pricing pressures in China headed? The bulk of the rise in Chinese PPI seems to have been driven by commodities, with little “demand side” pressure from the consumer goods side. The “Li Keqiang Index,” a weighted average of bank loans growth, electricity usage and rail cargo volumes is where we look to gauge where China PPI is heading. This should give us pointers on whether PPI pulls back as it did in 2006 or remains elevated as it did in 2010 to 2012.
2. Core Service Prices
Core service prices, on the other hand, are much more domestically orientated. Communications, housing, recreation and transport services are the main components we focus on, and their exposure to foreign competition is much lower than in the core goods segment. We use the price components of surveys such as the Institute for Supply Management (ISM) Non-Manufacturing Index and the European Commission Service Price series to provide an indication as to where these price pressures are heading.
The correlation of service price indicators to broad measures of Consumer Price Index (CPI) is weak, with longer lead times, in the region of 12 months. When we distil the services segment from within the CPI, however, we find a stronger relationship, and as services make up a large component of most CPIs, these indicators are invaluable.
The weaker relationships probably stem from the treatment of housing. In the US, the service CPI is dominated by the large weight for housing, especially owners’ equivalent rent, or OER. In Europe, the euro-wide services measure does not pick up the nuances in the peripheral countries such as Spain and Italy.
Nevertheless, these are powerful indicators. Exhibit 3 shows the price index within the eurozone survey of services (rising blue line) compared with the actual level of service price inflation (green line) and suggests actual service price inflation of around 2% in the near future.
Within eurozone service sector prices, one of the main stories over the last 10 years has been the structural change in their behaviour in peripheral countries such as Spain and Italy relative to core countries such as Germany. Prior to the crisis in 2008, periphery service inflation was around 1% higher than that of the core countries (Exhibit 4). After 2008, periphery service inflation declined, and in 2014 moved a full 1.5% below service inflation in EU core countries. Prior to 2008, peripheral service inflation was a key support for EU-wide inflation. Little wonder the European policymakers have recently struggled with deflation. More recently, periphery services inflation has risen. Should this rise be sustained, this could be a precursor to a higher and more stable core eurozone inflation rate.
3. Energy/Food Prices
Food prices are the least predictable component of global inflation impulses. The energy component of food production is high, so there is a degree of co-movement between the two. But weather, disease and supermarket price wars all make food prices relatively unpredictable in the short term.
Energy prices are a different matter. At Western Asset we pull together many different views across the Firm, from sector specialists within the credit market where energy-related companies issue bonds to fund operations, to our macro specialists.
The recent recovery in energy prices has largely been driven by OPEC and non-US, non-OPEC co-operation in an attempt to manage supply, with the objective of working off excess inventories of both crude and petroleum products. But, this market rebalancing has been complicated with the rebound in US shale production, as our US Credit Team advised. Consequently, oil prices remain depressed despite the current enthusiasm for the OPEC production agreement, ratified in May. We remain cautious, and maintain our $40-$55 trading range for West Texas (WTI) blend.
Experience cautions that geopolitics can add volatility to oil prices, and here the risks lie more towards the upside. For example, re-sanctioning Iranian production and renewed transit tensions in the Straits of Hormuz, off the coast of Iran, would be sufficient to drive oil prices higher and induce volatility.
Building Blocks—A Recap
As a quick recap, Exhibit 5 summarizes the three blocks that make up global inflation, and which drivers we look to for guidance on their direction and strength.
Having looked at each of the building blocks in the inflation process, we now turn to the impact that expectations can have on the inflation process.
This is perhaps the most interesting part of the inflation upturn we have recently observed. Heading into 2017, with oil prices recovering, most market participants expected headline inflation to rise. As time went on, the steep YoY falls that were dragging headline inflation down began to reverse. With oil at $53 bbl this February, the comparison with last February’s level of $30 bbl translated into a nearly 75% increase. These positive base effects can unwind very quickly, and we already see oil price appreciation of less than 10% when we compare current levels with May 2016.
This phenomenon should not have been a surprise, yet Exhibits 6 and 7, which show measures of inflation outcomes versus economists’ predictions, appear to tell a different story.
In Exhibit 6, we can see the path of the various “inflation surprise indices” calculated by Citibank, which compares the expectations of economists with the actual monthly inflation values as they are observed. At the global level, there is a sharp uptick (as surprises increased), but the biggest surprises were found in the economies that have weaker currencies: Europe and Japan. US economists seem to have noted the base effects quite well, even if the media rhetoric would imply that they too have been persuaded by the “reflation theme” post the US election.
Looking further afield, the strength we saw earlier in core goods price pressures and reflected in Chinese PPI seems also to have surprised economists. As Exhibit 7 shows, not only has the up move in Chinese PPI been swift, it’s also largely been unexpected. Additionally, as the move has progressed the surprise has grown; economists have clearly grown more sceptical as the price shock has taken hold.
In summary, around half of the move in inflation was not expected. Furthermore, the regional breakdown shows that the surprises have emanated from those with weaker exchange rates (Japan, the eurozone and China), whereas the move in the US (and in the UK where everyone has been waiting for higher inflation) has been much less surprising. While base effects have been the dominant driver of the recent recovery in global inflation, beneath this has indeed been an unexpected rise in core goods pricing.
The Impact of Inflation on Interest Rates
With the recovery of global inflation rates, financial markets have been forced to pay a little more attention, as evidenced by the rise in the observed correlation between changes in inflation breakevens and bond yields over the last couple of years (Exhibit 8). In addition, trading volumes have visibly increased around the publication of inflation data.
However, when we take this in the longer-term context, we can see that the sensitivity of nominal bond yields to inflation does not seem out of the ordinary, and may have simply returned to normal.
The Impact of Inflation on the Shape of Yield Curves
With regard to curve shape (as measured by the yield spread between 5- and 30-year bonds) the relationship can at best be described as loose and at worse the wrong way round. Normally, higher-than-expected inflation would lead to a steeper yield curve as the value of future nominal payments is devalued by higher inflation (and lower purchasing power). Recently the relationship in the US TIPS market has seemed counterintuitive, with the nominal yield curve flattening as inflation breakevens rose. The explanation probably lies with the volatility of inflation, and the “inflation risk premium”.
The Inflation Risk Premium—How Much Do Markets Care About Inflation?
Thus far we’ve avoided introducing a lot of jargon, but now might be the appropriate time.
When investors look at the return on inflation-linked bonds such as US TIPS, they have to consider both the real yield (a regular coupon-like income stream, inflation protected) and the actual inflation observed over the full holding period. That is to say, when purchasing US TIPS, investors receive the real yield, and unless inflation fails to show up, the return is supplemented by the actual inflation, say 2% per annum (pa) on average over the holding period (e.g., 10 years). Picture this as the real yield (say 0.1%) plus the actual inflation (say averaging 2% pa) to give roughly 2.1% annual total return.
If instead investors held a nominal US Treasury, which paid 2% pa, they would have been happier (at the margin) holding the US TIPS. Think of the breakeven inflation rate as the observed average inflation rate that generates the exact same return as the nominal Treasury, or at least makes investors indifferent.
It’s obviously not quite that simple, but for the most part, we can leave the “little details” to the markets to sort out. In essence, the breakeven inflation rate is the average inflation rate that provides the same total return as the nominal bond.
In our example above, the real yield is 0.1% and the nominal yield is 2.1% and it looks like the breakeven is indeed 2%. But if an investor’s expectation for the average inflation over the next 10 years is actually 2%, and they cared about inflation, they would want a little bit more compensation for holding the nominal bond. Let’s say another 0.1% pa. This is the inflation risk premium.
Inflation risk premia have been low recently and even negative in the past five years. Part of this has been the “cry wolf” mentality whereby the market expects inflation, only to be disappointed with the resultant disinflationary outcome.
Deflation prevention has been the hidden mantra for most central banks and this has only recently been repaired by the recovery in global inflation rates and renewed confidence in global monetary policies. Scepticism clearly remains, however, and it’s likely that the rebound in global inflation breakeven spreads has been met with a fall in the inflation risk premium. This would explain why the US yield curve has not steepened as breakevens have rallied. For a more normal US yield curve relationship to resume, we suspect we would need to see a much higher inflation risk premium, circa 25-50 basis points from current levels.
How Have We Translated All This Into Action?—The Implications for Portfolios.
At Western Asset we have tended towards long breakeven strategies over the past year, adding in early 2016 after the sharp fall in oil prices and concerns over both Chinese and US growth prospects.
The subsequent recovery in oil prices and the OPEC production deal in late 2016, combined with ebbing fears of a hard landing in China, set the stage for the surprise election victory of Donald Trump to drive inflation breakevens higher into early 2017. Upon reaching “fair value,” we subsequently reduced overweight breakeven positions throughout the Firm, viewing inflation as no longer “cheap”.
We are now more tactical in our inflation outlook, feeling the broad backdrop of modest global growth, and modest (but crucially positive) inflation provides a supportive backdrop for risk assets like credit.
Each major market is different, however. Through a pure inflation lens, in our opinion, UK index-linked gilts are currently very rich to where we expect inflation to end up. US TIPS, Japanese and German inflation-linked bonds appear fair value, while Italy looks cheap. At this current juncture we have a small overweight in breakevens in broad market, global nominal and global inflation-linked portfolios.
The Outlook for the Rest of 2017—The Last Word
Global inflation has recovered, and shows signs of a more durable and reliable stability—a welcome respite for policymakers and investors alike. This has important consequences for policy, and of course for markets, and we described how we are employing these themes in our portfolios.
We acknowledge the desire of central banks to normalize policy, while recognizing that they also rely on the continued improvement in global inflation trends and confidence that the trend of oil price weakness has ended, as well as the consequent deflation fears. The US Federal Reserve (Fed) has started the process of policy normalization but core inflation in the eurozone and Japan remains low and policy accommodation necessary.
Furthermore, we recognize the strong intent of the new US administration to “grasp the baton,” taking stimulus into the fiscal arena as the Fed proceeds to gently normalize monetary policy settings, both on the rate and balance sheet fronts.
Such a policy combination of looser fiscal and (gradually) tighter monetary policy settings should provide further support for the inflationary process, without undermining the US dollar and therefore sowing the seeds of its own downfall.
Little surprise, then, that we’re convinced the new-found enthusiasm for inflation is the least of our worries.
In a word, don’t be surprised to hear “Goldilocks” again, after a long hibernation.