There has been a material shift in central bank pricing since the start of the year. The Fed, who were priced to hike twice in 2019 not too long ago, are now priced to cut at least once. The ECB is not expected to get back to positive rates for at least three years whilst the RBA is fully priced for two cuts.
The move was originally driven by the Fed’s pivot towards inflation and their desire to avoid a de-anchoring of inflation expectations, a phenomenon that has occurred in Japan and Europe after years of inflation misses.
That said, unemployment rates are at multi-cycle lows across most developed markets, and in some cases, all-time lows. This begs the question, why is inflation so low?
Below I present a selection of possible reasons that may help explain the disappointing inflation dynamics.
Most economic models focus on the unemployment rate as a measure of slack, however, this is not necessarily the best measure. As labour markets have tightened, participation rates have picked up dramatically, especially amongst prime age women and older segments of the population. This trend cannot go on forever but there is still some scope for cyclical rises in participation rates. This keeps a lid on wage inflation and helps an economy to continue to grow above their potential without generating inflationary pressures.
2. Margins, not Prices
Whilst hidden slack may put a lid on runaway wage growth, we have still seen some progress in the last few years, especially in the US and more recently in the Eurozone. The Phillips curve is often described in terms of wage growth with the resulting assumption that higher wage growth boosts inflation (absent a rise in productivity). However, this wage-price relationship broke down some time ago. The missing link is profit margins. Globalization, technology and the spread of information has made it much harder for firms to raise prices, especially when inflation has been so well contained over the last few decades. Hence the more important series to watch is profit margins – if firms cannot raise prices, the next recession will come from stress on earnings rather than the central bank hiking to prevent inflation.
On this measure, we may still have some way to go. Whilst gross profit margins have fallen from their peak, last year’s tax cuts boosted net profit margins significantly whilst stronger economic growth has also fed through to gross margins to some extent.
3. What Inflation matters?
The problem with most inflation baskets is that not all the components are cyclical. For example, in the US, healthcare is greatly impacted by regulation whilst core goods are impacted by import costs. In fact, the most cyclical part of the inflation basket, shelter, has been rising at a steady pace. The rest of services CPI looks volatile and acyclical. Put simply, it is very hard to achieve an inflation target when such a large proportion of the basket is out of the central bank’s control.
4. The Amazon Effect
Structural forces also push down inflation, especially in core goods. Whilst online shopping does not directly impact CPI (due to outlet bias*), increased competition and better access to information puts downward pressure on the entire goods basket.
Splitting core goods (roughly 50/50) into an online** and offline basket, you can see that offline inflation is structurally higher than online inflation. You would expect this if goods that are traded online more frequently are subject to more competition.
The caveat here is that the difference in online and offline CPI (the following chart) has not increased. If anything, the big shift was during the 90s, and the difference has been relatively stable since. You can read this chart in many ways. My impression is that the Amazon effect impacts the entire goods basket (even the more offline segments) more so that it did previously.
5. Entrenched Expectations
This leads me to my final reason. Low inflation itself is a reason for low inflation. People are very much backward looking and successive disappointments in inflation, whether cyclical or structural, impact inflation expectations. It takes time to influence inflation expectations, hence the Fed’s desire to avoid the inflation trap that Europe and Japan find themselves in.
What does this mean for markets?
All else equal, central banks that are more focused on inflation will continue to keep monetary policy easier than previously expected, regardless of strong labour markets. Furthermore, given the myriad of structural forces and acylical inflation mentioned above, central banks may struggle to boost inflation consistently. Once you add the growing trade risks on top of this, we believe portfolios will continue to benefit from being positioned long duration.
*Outlet bias: Consumer shifts to new outlets, such as online shopping, is not well-represented by CPI since the difference in price levels between outlets is not captured.
**Online CPI: CPI of the most ecommerce intensive parts of the core goods CPI basket
In only the last three weeks or so, we have seen a head spinning progression of different narratives driving markets. Oh how I yearn for the anchor of the Three Phases Model now, but sadly its time has passed. For today’s post, I’m going to briefly cover a range of topics which span various themes. They may sound disjointed, but frankly, the market has been forced to lurch from theme to theme as monumental policy decisions are made, second-guessed, and occasionally rescinded by seemingly inscrutable human beings. The situations are frustratingly hard to analyze, but I offer some thoughts here nonetheless. This is not a commentary on whether the goals of the Trump foreign policy are potentially helpful to the long-run prosperity and security of the United States, but rather I’m trying to address the impact of a binary change in the short-term outlook for growth and financial asset prices.
By the time this note is published, I think it will be obvious, but the breakdown in US-China trade negotiations has abruptly taken over as the most important theme driving markets. If the global economy proceeds through the rest of the year with the most recent bi-lateral tariff hikes in place, those tariffs should be a material headwind to growth. A headwind, it should be noted, which was priced with only a miniscule chance of happening prior to Trump’s tweets on Sunday, May 5th, and which markets are still having a hard time accepting. So while the narrative of “trade war themes aren’t going away – just get used to it,” is an encouraging idea for those looking for risk market upside, the actual tariffs and lingering uncertainty are quite likely to genuinely impact growth precisely at a time when high valuations were built on green shoots of improving global growth in 2H 2019. Though of course, there is still a possibility that a “deal” will happen around the G-20 in late June, risk premiums ought to be wider now because the downside economic risk with persistent (or even higher) tariffs is significant. Global recession probabilities will need to rise.
Another consequence of the tariff hikes and postponed trade agreement is the sudden de-emphasis of the inflation data in the US as it relates to the likely monetary policy pathway. Fed Vice Chair Richard Clarida constructed a narrative ahead of the May 1st FOMC meeting that advocated for “insurance cuts” in the policy rate because inflation was persistently missing the 2% target. I had a blog mostly fleshed out in my head about whether more inflation was a good and desirable thing for the health of the economy or an absurdly inappropriate cost of living increase which would impact families inversely proportionate to their incomes. And then at the press conference, Chair Powell steadfastly refused to take the bait on the idea of “insurance cuts.” In fact the word “cut” was uttered eight times during the press conference, and all eight were journalists trying to trap him. In the days that followed, Clarida and others walked back the insurance cut idea, but then the whole thing was rendered moot by the breakdown in trade negotiations. From here, the future policy pathway is dependent instead on the trade war impact on global growth, and on the Fed’s response to foreign central bank monetary easing. Even if the US continues its record of exceptionalism versus other developed economies (quite likely in my view), the Fed would follow suit in leaning dovish into trade-related headwinds.
But what about inflation? Don’t tariffs raise prices? Well yes, that’s the whole point. But, much like a large energy price spike or consumption tax increase, this sort of inflation is not desirable, is generally considered a one-time spike, and the Fed would probably ignore it as a reason not to cut rates. In fact, tweets like the following illustrate the extent to which the Fed may be boxed-in by trade-related growth headwinds:
“China will be pumping money into their system and probably reducing interest rates, as always, in order to make up for the business they are, and will be, losing. If the Federal Reserve ever did a “match,” it would be game over, we win! In any event, China wants a deal!”
— Donald J. Trump (@realDonaldTrump) May 14, 2019
The president can pressure the Fed, but also the economic realities would probably justify a cut, so the Fed may struggle to distance themselves from the appearance of political interference. Additionally, the perceived ability of each country to respond as needed with monetary and fiscal stimulus is hardening their respective bargaining positions, and in my view reduces the chance of a resurrected comprehensive deal.
The upshot is that while risk assets may continue to experience bear market rallies, especially in the US where exceptionalism may even intensify, valuations need to adjust in aggregate to account for the material change in outlook for global growth in the past two weeks (purely due to human decision-making). As long as global growth concerns are still developing, interest rates should trend lower in yield regardless of whether markets expect central banks to respond dovishly, or central banks fail to see the need to respond, or in the extreme, if any response is ineffectual. Additionally, while the rapid reduction in US dollar liquidity I discussed two months ago did not, itself, trigger a risk-off move, the reserve drain did accelerate as planned and liquidity remains somewhat tight, which can exacerbate downside price action. One last comment on the dollar: it’s a countercyclical currency, especially when accompanied by US exceptionalism, so expect it to remain strong while the trade war narrative dominates and foreign central banks make the first dovish moves.