At this stage of the bull market, investors are facing a host of difficult questions. Do valuations matter? Why is volatility low when political risk is at an all-time high? Perhaps the most persistent question of 2017, though, is why is inflation so weak? Three managers interpret the data and explain what they’re watching.
View from mixed asset expert
James Swanson- MFS Investment Management
- Slow growth in China is feeding into the rest of the world
- Bond markets signal lower inflation ahead
- Earnings disappointment to come in second half
US inflation might be disappointing because China seems to be slowing down. It’s not collapsing or anything, but on the margins China helps to set prices around the world for lots of goods and services.
There is definitely a weakening in the property market there, and a year-on-year slowdown in industrial production and car sales. I think that is feeding into the rest of the world.
Here’s the biggest problem: there’s no rapid increase in inflation happening anywhere [in the world]. We have the latest Producer Price Index and Consumer Price Index numbers in the US and they were below what was expected, well below 2% year-on-year.
Inflation is not picking up in Japan and it’s not picking up in Europe. We tend to see inflation and pricing power this far into a business cycle, so companies can grow profits that way in the mid- to-late business cycle, but inflation is just now showing up.
My concern is partly because of the slowdown in China, and partly because of demographics and other trends.
The bond market is also very flat in terms of short-term rates versus long-term rates. That’s a sign that the bond market sees lower inflation and lower growth ahead.
I’m putting all these things together and I don’t think the market should be as excited about current conditions. It should be a little more worried. Are these earnings and cashflows going to keep growing? I don’t think so. I think we’re heading toward disappointment in earnings, year- on-year growth and revenues in these companies.
What I’m watching now is commercial and industrial loans from the banking side of things. Normally when you’re in a healthy business cycle, year-on-year growth will be going up. Instead it’s going down. Another thing is liquidity or money supply to GDP in other countries. The S&P sells a lot of goods to Europe, Japan and China.
Year-to-year money supply demand in all those regions is slowing down. All these things are telling me not to expect the good times to continue. Everything in the financial world is expensive, so everything is priced to perfection.
I’m sensing a slowdown in the second half and I don’t think the market can handle any sort of disappointment. Any reforms to the tax system would offer some short-term relief, but it’s not a permanent fix to the business cycle, especially as it’s built into the market already.
View from global fixed income expert
Rick Rieder- BlackRock
- Tech disruption is impacting traditional supply-cost dynamics
- Downward pressure on pricing can be seen across many industries
- Investors will have to scrutinize data more to discover sector trends
The CPI measure of US inflation came in below economists’ consensus expectations in August, and the July headline number represented the fifth weak result in a row. Many market watchers are again focusing on the disappointing headline number and taking a pessimistic view of the strength of the US economy, characterizing the current economic environment as one lacking demand-driven pricing power for companies.
I believe this interpretation misses the truth buried in the data. Tech disruption is having an epic impact on US consumption, driving one of the greatest supply-cost revolutions of all time.
In short, new disruptive technologies that are in demand with consumers are a powerful disinflationary force, holding down prices. A large part of what we’re witnessing here could be described as the ‘Amazon effect’; the e-commerce retailer is disrupting large swathes of the goods economy. But this disinflationary dynamic isn’t limited to e-commerce.
Take the transportation industry, and particularly the auto sector. Ride-sharing companies such as Uber, Lyft, and Via are disrupting the demand curves for auto purchases and the rental car business, particularly in major urban areas.
And electric vehicles are likely to disrupt the kinds of cars purchased and how much conventional fuel will be used in the years to come (see, for example, the high demand for the Tesla Model 3).
Expiring leases from the strong auto sales of recent years are already combining with fleet disposals from struggling rental car businesses to place significant downward pressure on used car prices. This in turn places downward pressures on new vehicle pricing and on the number of units sold.
In our view, what’s occurring in the auto industry now is unlike the dynamics of prior cycles, so history is unlikely to be a reliable guide.
These factors are ripping into the fabric of how we need to think about growth and inflation in this industry and more broadly. Other sectors and industries experiencing similar tech disruption include energy, telecom and hospitality.
We need to think about inflation differently to how we have in the past. It’s important to recognize the secular trends behind the data – namely technology disruption and changing demographics – and not to focus just on the frequently reported headline numbers.
View from US dollar bond expert
Keith Brakebill- Russell Investments
- Expects inflation to show up in second half of 2017
- Market has started to correct itself after post-election euphoria
- Phillips curve data is not as a meaningful as it used to be
We expect to see an uptick in inflation over the second half of the year. However, we are aware of the fact that we have been disappointed recently.
We had expected an air pocket in the first half of the year, as folks got too gung-ho about the new administration and the policies that were likely to be enacted. There’s always going to be some divergence between the euphoria of what seems possible and the reality of what can get passed, and obviously the implementation of that takes even longer.
We have seen an air pocket, but that's largely done. Now we should see an uptick in inflation going forward. We remain cautious of the breadth. In each individual inflation report, you can pick out a sector and say it’s impacting inflation and explain it away. But the fact that so many different sectors are continuing to contribute is something to be a bit wary of in terms of what that means for the macro economy.
I think we’re going to see increasing effects from full employment. We’ve seen lower- income wages rising, but it hasn’t fed through to the middle-income portion. As a result we haven’t seen that feed into consumer goods. The Phillips curve, which describes an inverse relationship between rates of unemployment and rates of inflation, is not what it once was. I don’t think it’s completely dead. You just have to look at the international markets a bit more.
International labor markets are moving toward full employment as well. It’s not just the US market, which has been ahead of everyone else. I think that will start to exert more pressure globally from the bottom up, but it’s a slow process.
As to whether that’s going to come in the second half of this year or next year, we’re not putting a lot our chips on that bet, so to speak.
If we continue to see disappointment with inflation, that is going to raise expectations for the Federal Reserve. It’s a real variable that the Fed will continue to focus on. They want to see more of the whites of the eyes of inflation – as do we investors – before we start to get really fearful of inflation.
This article was originally published in the September 2017 edition of Citywire Americas magazine. To subscribe and receive the magazine click here.