Iggo's insight: a view from the bond market - commentary from Chris Iggo, AXA IM - June 16th , 2017 - The long and short of inflation

16/06/2017

Since the financial crisis, monetary policy has been focussed on avoiding deflation. The targets have been clear – restore inflation to the central bank Holy Grail level of 2%. Over the last year, with a broader economic expansion developing, confidence in reaching that target has increased. Indeed, the US Federal Reserve (Fed) has started to normalise interest rates as it feels inflation is set to return and stay on target. The European Central Bank (ECB) is looking forward to being in the same position, but it is not there yet. But markets have nagging doubts about longer term inflation trends. What if inflation remains low? What do we understand about why that might be the case? It’s complex but it might be the case that monetary policy just does not have enough tools (interest rates and balance sheet) to challenge structural deflationary forces. The hope for at least more cyclical inflation remains with the US and that a tight labour market pushes up wages. More so if the economy is boosted by tax cuts. President Tweet remains as important to market sentiment as he has done since last November. If his Administration does not deliver, we could re-test the lows in global bond yields.

 

Do you believe in the Fed?

The Fed raised its key policy rate again this week to target a range of 1.0% - 1.25%. It did so against a market backdrop of lower bond yields and reduced inflationary expectations in part driven by lower realised inflation numbers in recent months. I have mentioned before but since the beginning of the year, a period in which the Fed has delivered two rate hikes, overall monetary conditions have eased with lower bond yields, tighter credit spreads, a weaker dollar and higher equity valuations. Moreover, the divergence of market pricing – in the rates market – from the Fed’s own interest rate forecasts has increased. The Fed seems to be insisting that any weakness of inflation will turn out to be temporary and with the labour market still tightening, the risk is that inflation will be provoked by higher wages and this will necessitate further interest rate hikes. Either the Fed will turn out to be wrong and will not be able to hike as much as another 175 basis points (bps) over the next two years or the bond market is in for a major correction and 10-year yields are heading to 3.0% rather than below 2.0%. It’s not just expectations of Fed policy that reveal a divergence. The rates market is showing signs of pricing in an economic slowdown – lower yields, less tightening and a flatter curve – while risky assets such as credit and equities are priced for continued economic growth. What is the data telling us? Well you could look and probably find growth momentum slowing but it is hard to argue that this is nothing more than normal noise in the data. I am partial to the view that economic expansions don’t die of old age and that there needs to be something that causes a slowdown – tighter policy or some kind of shock. I am also partial to the short term view that disappointment over Donald Trump’s ability to progress on tax reform and infrastructure spending has punctured the Trump trade and the upward revisions to growth and inflation that were made following his election last November have been all but reversed. So we are back to growth that is around 2%, inflation that is around 2% and a tightening cycle that is what I have started to call “opportunistic normalisation”.

Bond yields lower

We will see how it evolves in the US. My view is that growth expectations could be revived again. I find it hard to think that the US Administration will give up on tax cuts given that the Republicans are in complete control and that they face mid-term elections in 2018. Even if the tax cuts don’t do much for growth – and they would need to be heavily weighted towards reducing household taxes to have a meaningful effect – the impact on confidence could be significant and could extend the life of the current expansion in the US. Under such a scenario, market pricing would need to move closer to the Fed’s own forecasts. Continued positive news on other major economies (I will exclude the UK from this) would underpin this scenario. Bond yields would struggle to stay at their current lows and we would see yields back to the upper half of the ranges that they have traded in during the first half of 2017. However, for the moment that is not the narrative in the markets and a test of last year’s low in yields could be seen if there is some weaker data.

Back to Trump

Imagine that the Fed is right though. It will raise rates to over 2% by this time next year. It also said that it will start to reduce the amount of balance sheet re-investment as Treasury and mortgage-backed securities mature from September onwards. That means marginally less buying of bonds by the Fed compared to recent years at the same time as the Federal budget deficit is likely to be increasing and the ECB will be starting to taper its bond purchases as well. It may be marginal to begin with but the net buying of bonds by central banks will start to go down. I have certainly put a lot of stock on the view that central bank purchases have been a major positive technical support to global bond markets so a reversal of those purchases, even a very small one, would take away some support from the market. Is the ECB ready to follow the Fed? Can it join in “opportunistic normalisation”? Not really in my view. There is still spare capacity in the euro area, there is still very low inflation with the core measure a long way from the official target of close to but below 2.0%. But technically the ECB needs to reduce its purchases because of it getting close to the imposed limits of the programme. So tapering is likely to begin in January 2018, very slowly, and rates won’t be increased for at a least a year after that. The opportunity to completely exit is not as clear a one for the ECB as it is for the Fed. This should mean Treasuries underperform Bunds and the dollar is stronger, but these trade ideas are very dependent on markets returning to the theme of higher inflation and the Fed being able to stick to its plans. That in turn depends on fiscal stimulus.

Less people, less inflation

Having said that the Trump trade could make a return, there is a not insubstantial risk that exit might prove to be more difficult than currently envisaged and that risk really revolves around the inflation outlook. If inflation does not move higher then monetary policy will be judged to have failed. It will be argued that quantitative easing did not go far enough. It might be argued that Milton Friedman was wrong and that inflation is not always and everywhere a monetary phenomenon or that at least policy makers failed to see all the impediments to boosting inflation despite monetary creation on an unprecedented scale. I have been doing some reading around the link between demographics and inflation and empirically there is a lot of evidence that factors such as fertility rates, dependency ratios and population growth as a whole have an impact on longer term inflation trends. Look at Japan as an obvious example. The population has been shrinking for years and there is no inflation and the Bank of Japan is still struggling to generate inflation with a monetary policy that is propelling its balance sheet size to be close to 100% of GDP. The theory is quite simple. Less people means less aggregate demand. In a closed economy it would also mean less supply so both the demand and supply curves would move and price inflation might not be affected. But most economies are not closed and supply is plentiful. In addition, Japan’s economic success has been based on exports and it has developed a lot of the technology that has also generated lower inflation. Taking the G7 countries together, total population growth has been negative for some years and when this is charted alongside inflation the correlation is clear. A shrinking population means an ageing population that saves more so the impact on aggregate demand not only comes from less people but from those fewer people spending less than they did when they were young.

People make the difference

In thinking about demographics I also looked at per capita growth data for the major economies. If GDP is adjusted for population, Japan has pretty much done the same as the US in recent years, but clearly total GDP growth has been lower. Interestingly, the standard deviation of per capita growth rates amongst major economies has been falling over the last couple of decades – meaning per capita growth rates have become more similar amongst the major economies. This is probably related to globalisation, capital flow arbitrage and the adoption of universal technology and production methods. Anyway, I thought it was interesting. Individuals in different economies have experienced similar income trends but economies as a whole can show very different aggregate growth rates with the swing factor being the differences in population growth. For a business targeting global markets wouldn’t you just first write down a list of the countries with the best demographics? I guess this is a fundamental reason why there is such long-term faith in emerging markets which tend to have higher rates of fertility and faster population growth as a result (although, like everything the picture is mixed). Demographics have complex implications for economies. I would suggest that Japan also points to a scenario where lower population and the associated weakening of aggregate private demand necessitates increased public spending in order to make up the short-fall, particularly when a higher dependency ratio weakens tax revenue and the funding of public services. Japan and Italy have poor demographics and unsustainable long-term public debt ratios. Germany has been more willing to accept immigration to offset its challenging demographics and thus has a better fiscal position (amongst other reasons). The ageing of society also has implications for health and social care provision. My brother-in-law works for a Japanese electronic component maker and the biggest growth area in recent years has been in new technology to help “health detection” for older people in their own homes or in sheltered accommodation. My equity colleagues in AXA IM Framlington Equities are developing the very related themes of demographics and robotech in some very interesting stock strategies.

Have kids, print money

The link between demographics and inflation is conceptually appealing. The effects are seen over the long-term and it may be that we have really underestimated these forces and focussed too much on trying to get inflation going again by trying to encourage leverage and by boosting asset values. But the population is getting older, it is not growing and has amassed a lot of debt, so it is proving to be much harder to raise inflationary expectations and spending. So if rather than the death of inflation we think about the death of monetary policy, where should policy be focussed? To boost medium term inflation trends, shouldn’t the focus be on improving demographics by increasing fertility rates, allowing more immigration in demographically challenged countries and stopping the increase in the dependency ratio by making it more attractive for people of the right age to enter the workforce? On the macro policy side, it may be that even more quantitative easing is needed, going to outright monetisation of public debt so that fiscal spending can boost aggregate demand (and even influence demographic trends – favourable tax treatment for parents to encourage higher fertility rates, and so on). The long decline in inflation since the early 1980s is often explained by the aggressive monetary and fiscal policies of the Reagan-Thatcher era, globalisation, reduced trade union power and digitalisation but demographics have clearly played a massive role. It’s certainly not conventional wisdom to allow more immigration into developed economies because the focus is always on the need to provide public services but it is often ignored that his can also contribute to aggregate demand and a more efficient labour force.  Perhaps because demographics are slow moving they tend to be ignored by policy makers on the whole, and by financial market participants.

Oh, Britannia

I apologise for digressing into these complex issues that I have only a superficial understanding of. The reason is that my fixed income views have generally been formed by an expectation that inflation would eventually be boosted by the extraordinary monetary policies of recent years and it hasn’t. Global aggregate demand remains insufficient and the need to stimulate growth through fiscal policy is being held back by emphasis being put on redistributive policies or balanced budget ambitions. Cutting, not raising, taxes would help boost disposable income but this would need to be complimented by much needed spending on physical and social infrastructure in many countries. Those per capita growth rates need to be increased everywhere before we can really forget about deflation and to get that to happen we need to provide jobs and better incomes because in recent years growth has not only been insufficient it has also been unequal. Of course, many of these issues were discussed during the recent UK election but the outlook for policy there is as clear as mud. Immigration is seen as bad. Fiscal policy is only discussed in terms of either re-distribution of wealth or financial conservatism. The Bank of England, amazingly, had three votes for a monetary tightening in June when almost everyone agrees that the recent rise in UK headline inflation is entirely down to the weakness of sterling. Wages still aren’t growing. Crikey, if we want to start the next deflationary cycle in the UK then crack on and raise rates. That is just what a teetering housing market needs right now, not to mention the impact on consumption and investment as the country starts Brexit negotiations. Last week I suggested that gilts could underperform other bond markets if the government responded to its poor performance in the election by loosening fiscal policy. If they don’t and if people think interest rates are going up, then gilt yields might actually converge on German levels, especially if unemployment starts to reverse later this year or into 2018.

Rates or credit?

So, to recap. Markets are currently displaying fears over the cycle in the US, are questioning whether the Fed can raise interest rates as much as it suggests and have lost faith in the Trump Administration being able to deliver fiscal stimulus. Together with an ongoing strong liquidity provision by central banks in Europe and Japan, this has pushed bond yields down. All of this could reverse with stronger data and some tax cuts. However, the Fed told us in its statement to watch inflation. That is crucial in the short term as it could be the case that the Philips curve is alive and kicking and we will see higher wages at some point. If not, then long term investors need to consider the more structural forces keeping inflation down. If inflation is permanently lower then interest rates will remain permanently low too. Under these conditions, I would worry much more about credit spreads than rate increases as continued, but ultimately futile, financial repression will inevitably lead to a bubble that bursts.

Have a great weekend,

Chris

CIO Fixed Income, AXA Investment Managers

 

All data sourced by AXA IM as at 16 June 2017.

 

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