Are global forces impeding inflation?

In an earlier insightinsightinsight, we noted that inflation expectations have had little predictive power on actual inflation. Here, we look at how globalization has become a headwind for inflation, focusing specifically on China’s impact on recent disinflationary forces globally, and the impact of the stronger dollar on the cost input side.

The U.S. economy has become increasingly open

Inflation rates around the world have converged

Are global forces impeding inflation? View larger version

Source: Bloomberg. OECD refers to the Organization for Economic Cooperation and Development.

When the Cold War ended, the U.S. economy, as with those of many other countries around the world, became more open. The share of exports and imports in gross domestic product (GDP) — a proxy for economic openness — indicated an acceleration in openness in the early 2000s. Around the same time, inflation rates around the world converged.
China’s inflation picture

Enter China

China’s economic evolution in recent decades is relevant to both increasing globalization and its impact on inflation around the world. The divergence in Chinese inflation from that of the rest of the world in the mid-1990s reflected both the Chinese economy also having opened up after the Cold War as well as the local imbalance between pent-up demand and available goods, especially food items. During the 1997 Asian crisis, the shock to aggregate demand dropped inflation to the other extreme. Since the crisis, however, China has seen explosive economic growth driven by exports and infrastructure investments.

As of 2010, China’s share of world commodity consumption stood at 53% for cement, 48% for iron ore, 39% for copper and 48% for coal (according to the World Bank). At that time, China’s GDP growth peaked at 12% and by 2013 official statistics were showing GDP at a still strong 8%. China underwent a political change of guard in 2012, and began the transition to a less investment driven and more consumer led economy. The Thomson Reuters/CoreCommodity CRB Index, a broad commodity index, peaked at 350 in 2012. One year later, however, commodity prices fell by 14%. This was the first leg of the global disinflation cycle, which has been largely a story of demand rebalancing. (Data: World Bank.)

Commodity prices

As global demand rebalances, commodity prices have fallen

Source: Bloomberg. The Thomson Reuters/CoreCommodity CRB Index is a commodity futures price index.

Setting off global deflation

Disinflation, overvaluation, and some stabilization

In line with process of demand rebalancing, home prices in China have come under pressure recently and its stock market currently looks overvalued. The rebalancing in China has been an important factor in unleashing the global disinflation cycle that we believe we are currently living through. As the degree of the stock market’s overvaluation indicates, however, China still has a long way to go.

Chinese equities overvalued

China’s stock market appears to be in bubble territory

Source: Bloomberg. The Shenzhen Composite Index is one of three stock exchanges in the People's Republic of China. It lists more than 1,500 companies, most of which are controlled by the Chinese government. P/E ratio is a valuation ratio of a company’s current share price compared to its per-share earnings.

Stabilization is in sight

China's economy seems to be stabilizing

China’s economy seems to be stabilizing as a new stimulus scheme designed to replace trillions in questionable municipal bank loans with government-backed bonds presumably could free up the balance sheets of local banks and encourage more lending. The program is off to a slow start because banks are reluctant to take down the bonds, but China’s economic indicators have at least remained near the trough, rather than continuing to decline (see next slide).

Performance relative to analysts’ expectations

China’s economic indicators remain near the trough

Source: Citigroup. The Citigroup Economic Surprise Index is a rolling measure of beats and misses of indicators relative to consensus expectations.

But headwinds could threaten

A deflationary trend in China

If China's stock market crashes, however, the blow to households is likely to be severe enough to stop the improvement in its tracks. If so, inflation would decline, not just in China, but around the world.

Add to the list of worries the foreign exchange transmission mechanism. Recently, it has been in China’s interest to hold the yuan steady to support aggregate demand and get better recognition of its currency in international circles. However, the Chinese yuan represents 21% of the trade-weighted dollar. The euro is the second biggest weight at 16%. Weak economic growth and divergent monetary policy in other countries may feed into upward pressures for the U.S. dollar. (Data: Federal Reserve.)

Outright deflation makes an appearance

A deflationary trend across Asia

Meanwhile, the deflation story is becoming more entrenched in Asia ex Japan in spite of inflation stabilizing in the U.S. and Europe. Thailand’s consumer price index deflation experience is now increasingly widespread throughout the region.

Asian consumer prices: What the data say

Consumer price indices in decline

Source: Bloomberg.

A strong dollar playing a role

The strong dollar – A historical perspective

The strong dollar has been a common topic among investors recently and is equally relevant to the inflation outlook. By historical standards, however, we do not view the dollar as being overvalued. Looking at previous cycles, the dollar has tended to move in five-year intervals between bull, bear, and sideways trading patterns. Prior bullish trends have extended 47% on average and lasted about five years. In 2014, the dollar moved above 80 (the high end of the range that prevail since the global financial crisis) and is currently 13% higher. (Source: Federal Reserve.)

A historical perspective on dollar strength

U.S. dollar: More room to run

U.S. trade-weighted dollar is a measurement of the foreign exchange value of the U.S. dollar compared against certain other foreign currencies.

Forecasting the effects of currency moves

U.S. dollar: More room to run

These numbers are important within an inflation context because the Federal Reserve’s FRB/US Model, a tool for macroeconomic analysis, forecasts the impact on core personal consumption expenditure (PCE) from a 10% currency shock to average -0.2 to -0.5 percentage points over 5-15 months. In other words, the first leg up in the dollar rally is still in the process of filtering through to core inflation, and as the historical record indicates, there could be further gains ahead. However, unprecedented monetary policy around the globe could impact historical cycles in unexpected ways.

A visual diary: When exchange rates shift
Are global forces impeding inflation? View larger version

Source: Federal Reserve.

A slow path toward normalized rates

Some conclusions

When assessing inflation, it’s important to consider the linkages that exist throughout our global world. Moving toward the Fed’s inflation target is a complex issue, reliant on factors outside the U.S. On one hand, given the background presented here (and the China story in particular), it is questionable whether the Federal Reserve will be confident that inflation will move back to its 2% objective. Add to this the persistent fall in commodity prices and low CPI figures from emerging countries, and the path to interest rate normalization seems like it could be slower than expected. On the other hand, for investors involved in markets that are fully valued by historical standards, the trajectory of inflation will impact performance.

Our global investment team believes the fixed income markets are efficient with respect to interest-rate risk, but regularly misprice securities that are exposed to credit, prepayment, liquidity, and currency risks. As such, we are keenly aware of the potential impacts that the larger macro-oriented issues such as inflation and liquidity may have on the markets, and securities, that we cover today. We will continue to consider how investors’ perceptions, or misperceptions, of these issues may impact the pricing of individual bonds before adding, or keeping, any security within the portfolios we manage.

Launch slideshow

Charts are for illustrative purposes only.

The views expressed represent the Manager's assessment of the market environment as of July 2015, and should not be considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to change without notice and may not reflect the Manager's views.


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