Inflation, or the lack of it, is a key global risk

The inflation rate is always a concern for financial markets and investors. Too much inflation erodes buying power, elevates borrowing costs for homebuyers and businesses, and subtracts from real investment returns. Too little inflation often correlates with lack of investment in business opportunities, sluggish economic growth, stagnant wages, and poor investment returns.

In the current debt supercycle, central banks have stepped to the forefront, issuing unprecedented amounts of sovereign debt — at historically low rates — originally to pull their countries’ economies out of the deep recession of 2008–2009, and then in attempts to prod economies that have been persistently lackluster. Hoping to stimulate demand, the European Central Bank (ECB) instituted negative interest rates in 2014. The Bank of Japan (BoJ) followed suit in early 2016, as did the central banks of Sweden, Switzerland, and Denmark.

In the United States, viewed as further along in the current cycle, the federal funds rate is nominally positive at 50 basis points (0.50%). But a number of factors, including concerns about global economies, have led the U.S. Federal Reserve to postpone plans several times through 2016 for slow but steady rate hikes.

In this context, the role of inflation — and the current lack of it — has become a key focus for the world’s markets and one of the risks facing investors. That makes it important to understand the dynamics of inflation in the new global economy.

An eye on inflation

Inflation is a complex topic with several theoretical models that are debated by economists. We believe that there are two types of inflation. The first results from price shocks, typified by the episodic shortages of oil since the 1970s. The second type of inflation is demand-driven and more difficult to measure in a precise way. Typically, policy makers gauge the picture of demand-pulled inflation through signals that include increasing wages, narrowing output gaps, and advances in productivity.

Inflation is not the only scenario. There are also periods that are disinflationary, or worse, deflationary. If inflation represents an increase in prices, then disinflation is a decrease in the rate of inflation, and can be as benign as the period following the severe inflation of the 1970s when the inflation rate decelerated. Deflation, with prices falling over time, can have profound consequences if it occurs over a sustained period as in the Great Depression.

While rampant inflation can also be problematic, persistently low inflation rates or disinflationary periods, which we seem to be experiencing, can pose challenges. For example, in the current environment of near-zero and negative interest rates, central banks are unable to use inflation as a signal to tighten monetary policy and raise rates. In our view, continued disinflation is a likely scenario, while the risk of a deflationary period cannot be ruled out.

Historical context

Looking back over the past 50 years, inflation trends were characterized by three regimes. The first was basically the inflationary period catalyzed by oil-price shocks and the zenith of labor-union leverage.

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Recent history of U.S. inflation

Chart 1. Recent history of U.S. inflation

Fed Chairman Paul Volcker put his signature on the second regime with unprecedented tight money policies. Beginning in late 1979, he began raising the federal funds rate to a high of 20%. In short order, inflation fell from 14.8%, its peak in March 1980, to less than 3% in 1983. This big win marked the advent of inflation targeting for central banks.

The third regime began in 1990. This was not driven by a price shock or a change in monetary policy, however. Instead, the opening of developing markets, particularly China, began to change the supply-and-demand dynamics of the global economy. The global financial crisis of 2008–2009 devastated asset prices worldwide and severely depressed demand.

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Chart 1. Recent history of U.S. inflation

Data: Bureau of Labor Statistics and Bureau of Economic Analysis

Core CPI: Consumer price index (CPI) excluding food and energy prices.

Core PCE: Personal consumption expenditures (PCE) excluding food and energy prices.

Core CPI ex-shelter: CPI excluding food, energy, and housing prices.

Fed target: Target inflation rate for the Federal Reserve.

Chart shown is for comparison purpose only.

A longer look at U.S. inflation history

Currently, it seems odd for a period of disinflation to persist. However, a longer history of U.S. inflation gives a different perspective. Prior to the establishment of the Fed in 1913, the economy was experiencing inflation less than one-third of the time. After 1913, that number increased to 84% — and 96% for the post–World War II era. Now that central banks’ traditional tools are failing to have an impact — with countries resorting to zero-interest-rate and negative-interest-rate policies (ZIRP/NIRP) — could the odds of deflation revert to their long-term historical averages?

  Overall, since 1800 1800–1913
(Pre-Fed period)
1913–1945
(Period from start of Fed to World War II)
Post–World War II to present
Deflation 32% 47% 14% 4%
Mild (-0.4–0% year over year) 19%
Severe (< -4% YoY) 13%
Inflation 56% 30% 84% 96%
Mild (0–4% YoY) 36%
Severe (> 4% YoY) 20%
Zero inflation 12% 23% 2% 0%

Data: Bianco Research, 2016

Debt levels

People tend to assume that periods of high debt will also be inflationary. Currently, in the debt supercycle, U.S. and global debt is very high relative to gross domestic product (GDP). Yet the core PCE price index — the measure of personal consumption expenditures (PCE) that is the Fed’s preferred measure of inflation, which is currently 1.6% — is lagging both its long-term average of 3.3%1 and the Fed’s target of 2.0%. Moreover, the disinflation trend has been a global phenomenon, not singular to the U.S.

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Global disinflation trend

Chart 2. Global disinflation trend

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Chart 2. Global disinflation trend

Data: Bloomberg

Chart shown is for comparison purpose only.

The problem is sluggish demand. We see this quantitatively in the subpar economic growth numbers worldwide. Instead of money being deployed in productive investments, the net result is the concern that asset bubbles may be building in certain markets such as real estate (as occurred in the early 2000s in the U.S. and later in other countries) or that investors are chasing yield in financial markets.

Labor markets

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U.S. labor force participation

Chart 3. U.S. labor force participation

A similar, counterintuitive situation exists in U.S. labor markets. The headline unemployment number dropped to the 5.0% threshold in October 2015, and has been consistently falling. This is technically full employment, which ordinarily causes inflation to pick up.

However, broader measures of the labor market tell a different story. The labor force participation rate has been coming down since 2000. And jobs created since the financial crisis disproportionately have been part-time, low-paying work. All told, there is residual slack in the labor markets, which is disinflationary.

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Chart 3. U.S. labor force participation

Data: Bureau of Labor Statistics

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Wages and inflation

Chart 4. Wages and inflation

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Chart 4. Wages and inflation

AHE YoY correlation vs. core PCE YoY
Period Correlation
1965–1990 0.72
1990–2016 0.18
1990–2007 -0.07
2009–2016 -0.51

Data: Bureau of Labor Statistics and Bureau of Economic Analysis
AHE denotes average hourly earnings; PCE, personal consumption expenditures

Charts shown are for illustrative purposes only.

The growth of China

How much of this labor market slack, if any, is due to globalization? This is one of the topics we examine most rigorously in our analysis.

There is no doubt that the U.S. became more open to international trade after the Cold War ended in the early 1990s, as China was entering the global economy. Chart 4 plots China's economic growth — historically export-driven and heavy on manufacturing and infrastructure — versus the Thomson Reuters/CoreCommodity CRB Index, which is a broad global commodity index. This correlation affects inflation on the cost side.

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Slower growth in China can affect commodity demand

Chart 5. Slower growth in China can affect commodity demand

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Chart 5. Slower growth in China can affect commodity demand

Data: National Bureau of Statistics of China and Thomson Reuters

Indices are unmanaged and one cannot invest directly in an index.

Chart shown is for comparison purpose only.

China was originally a manufacturing source for the U.S. and other developed economies. We can clearly document the increase in cross-border capital flows and declining labor costs in advanced economies’ outputs as the outsourcing trend took hold.

Our analysis also points to a break in the link between wage growth and inflation. When charting wage growth and inflation rates, we observe a close correlation between wages and inflation prior to 1990. At that point, more noise appeared in the signal. And, beginning in 2007, the correlation actually started to turn negative!

This is a key point to keep in mind as the Fed, and other central bank policy makers, tend to emphasize wages as one of the key components of inflation. We have to ask ourselves if we might be entering a new regime where the old relationships don’t hold up. The jury is still out, however, and we’ll be watching to see what results from a recent uptick in wages.

Commodity prices

Recent signals from commodity prices have been confusing at best. I already noted the correlation between China’s GDP growth rate and commodities prices (see Chart 5). More specifically, in 2010, when China’s growth rate peaked at 12%, it was consuming nearly half of the world’s key industrial materials: 53% of cement, 48% of iron ore, 39% of copper, and 48% of coal.2 By 2013, official statistics showed China’s GDP declining to 8% growth, and commodities prices falling by 14%.3 This is an example of demand rebalancing, but it was also the first chapter of the global disinflation cycle.

Now, as we’ve moved to chapter two with commodity prices, the storyline has become murky. After more than a year of generally falling prices for many commodities, especially for oil, which fell to as low as $30 a barrel in early 2016, there has been some recovery. In May 2016, when oil rallied, inflation expectations moved in the opposite direction and the Treasury curve flattened. These divergences are counterintuitive and go against historical experience. The same is true of the price of copper, which also diverged from its historical correlation with oil prices.

Faced with uncertainty, a focus on fundamentals

By now, we believe, the pattern should be clear. Lack of demand is the culprit. But what can be done to stimulate reflation? Policy makers have tried everything in the standard repertoire and have resorted to unorthodox measures as well. Easy money, easier money, multiple rounds of quantitative easing, ZIRP, NIRP…nothing seems to have had a real impact.

We are experiencing a secular downward trend in inflation, and the reality is that central banks have been missing their inflation targets for the past four years. This cannot fail to create a sense of profound uncertainty.

With near-zero and negative interest rates, central banks can do little to stimulate demand. But as market participants, we have to ask ourselves if we’re entering an environment parallel to the pre-1913, pre–Federal Reserve era, when deflation was the more frequent threat to economic stability.

To avoid misallocations of capital, we are exploring issues like this — trying to decipher the new macro environment, so we can continue to make good decisions. The full ramifications of globalization are not yet apparent. For example, as technology continues its advance, are we measuring productivity the right way? What are the implications of artificial intelligence for the traditional framework of measuring inflation and, specifically, for wage growth?

For the near term, we expect disinflationary forces to persist. In particular, we are monitoring wage inflation on the demand side and the impact of the stronger dollar on the cost side. The risks inherent in this volatile and unfamiliar market environment only highlight the importance of a research-intensive, fundamental investment process such as ours, which offers the potential to endure market turbulence related to the inflation dynamic.


1Source: Bloomberg

2Source: World Bank

3Source: Thomson Reuters/CoreCommodity CRB Index

The views expressed represent the Manager's assessment of the market environment as of August 2016 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.

IMPORTANT RISK CONSIDERATIONS

Investing involves risk, including the possible loss of principal.

Past performance does not guarantee future results.

International investments entail risks not ordinarily associated with US investments including fluctuation in currency values, differences in accounting principles, or economic or political instability in other nations. Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility and lower trading volume.

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