Where is the inflation? In asset prices

In recent years, global central banks have made a strong effort to revive the economies by cutting rates to zero or negative and pumping large amounts of money out through quantitative easing (QE). Since 2008, the Fed, Bank of Japan and Bank of England have bought assets amounting to USD5trn, corresponding to about a third of US GDP. The QE sceptics warned that QE could end up in a burst of higher prices as inflation is ultimately a monetary phenomenon. However, despite the significant increase in money, there is very little sign of consumer price inflation – on the contrary, the predominant concern is rather deflation or too low inflation relative to central bank targets around 2%. 

However, it’s not true that there is not any inflation. It’s just not in consumer prices. Instead, it is showing up in asset prices. Pretty much all assets have been going up in price for some time and many of these have now become expensive – some even very expensive: global stocks have increased 50% over the past two years and valuation in several key markets is starting to look stretched. High-yield spreads are trading only marginally above the spreads prevalent ahead of the financial crisis. Government bonds in peripheral bond markets have had a remarkable performance – 10-year Spanish yields are now at 2.65%, the lowest level in 200 years. In core government bond markets, German 10-year government yields at 1.25% are close to the lows during the euro debt crisis. 

The truth is that it’s very hard to create consumer price inflation when a) unemployment is very high and wage growth therefore subdued and b) a positive supply shock (this time shale oil) is adding to the downward pressure on inflation. Central banks are pushing on a string and the more they push the higher the risk of new asset bubbles. Choosing between two evils, it might be that inflation below target for some time is better than the risk of creating new asset bubbles, which could ultimately lead to a new financial crisis and a high risk of deflation at a later stage.
 
More than ever, central banks have to be very alert to the creation of new bubbles. The environment of very low rates and global economic recovery seems likely to be with us for some time and this will continue to encourage a very strong search for yield. With cash rates at zero, how do you give your clients a return without buying assets such as stocks and credit bonds? As long as the macro environment is one of recovery, history suggests that investors will continue to buy risk assets when rates are so low. It means we again get trades that are very crowded and a risk that leverage slowly goes up in order to get the desired return at lower risk premia. As we have stated, our own view is that risk assets will continue to outperform as long as recession risk is very low and investors are forced out on the risk curve to get a return. This could go on for an extended period. However, one has to keep a close eye on valuation in coming years and be aware that when the tide eventually turns, there is a risk it will get ugly. The more central banks keep pushing on the string, the higher this risk becomes. 

US bond yield conundrum – part 2?

Contrary to our and consensus expectations, bond yields in the US moved lower in the first part of 2014. This is despite unemployment in the US having continued to decline, core inflation having turned higher lately and the Federal Reserve having raised its forecast for the Fed funds rate path twice over this period (the Fed’s end-2016 projection has gone from 2.0% in December 2013 to 2.5% in June). 

However, some other factors have pulled in the other direction. First, the ECB has provided more stimulus pulling German yields much lower with some spill-over to the US. Second, the Fed has revised down its long-term estimate for the Fed funds rate to 3.75% from 4.0%. This seems justified based on very poor productivity growth for some time, which partly explains why unemployment has fallen so much even with growth only around 2-2.5%. 

Another factor that may be at play here has to do with the significant amounts of money sloshing around the global financial system. This has some resemblance to the conundrum period in 2004-05 when the Fed was hiking rates, but 10-year yields went nowhere and were range bound for two years. It led to a substantial flattening of the US yield curve. Explanations at that point were mainly a) the global savings glut pushing up bond prices and b) the so-called ‘measured pace’ hiking cycle gave bond investors comfort that we were not going to see unpleasant surprises in terms of sharp rate hikes, as was the case in 1994. 

That environment may not be much unlike what we are seeing today and can expect in the coming years. The Fed has told us that when it starts to raise rates it will happen at a very gradual pace. Global liquidity is likely to remain ample as the Bank of Japan will continue to print large amounts of money, the ECB is adding more liquidity later this year and the pension industry continues to receive large inflows in the western world as pension systems are in the process of being built up. Finally, the lower long-term Fed funds rate has lowered the anchor for long-term forward rates. 

It suggests to us that long-term bond yields will only see a moderate increase even as short-term bond yields move higher when Fed hikes move closer and once the Fed starts hiking. We believe we will see another significant flattening of the US yield curve over the coming years. 

Markets in short-term correction mode

Over the past week stock markets took a breather. Focus turned to geopolitical risks in Iraq and profit taking set in after the past weeks’ rally. The situation in Iraq is more likely to be an excuse for correction rather the real reason. Stocks had gone into shortterm overbought territory and this is often followed by a short-term correction. The  medium-term upward trend is still intact though and, as stated above, we are still positive on risk assets. 

The decline in EUR/USD has also taken a pause but it also comes after hitting short-term stretched levels on a technical basis. At the same time, positioning is short the  euro and it creates some tailwind to EUR/USD for now. However, we still strongly believe the tide has turned for EUR/USD and diverging monetary policy will increasingly push the cross lower.

In commodity markets, the oil price moderated somewhat falling to USD113 per barrel (Brent) after hitting USD115 per barrel last week. Measured in euros, the oil price is up 6-7% over the past two months and it may give a small lift to euro inflation in coming months unless it falls back quick. 

Euro growth slows while China speeds up

On the macro front we saw further confirmation that the euro recovery is moderating, while China is speeding up further. Euro PMIs and German ifo expectations index fell a bit more than expected as the euro economy is digesting the slowdown in US and China earlier in the year. However, as domestic demand is still recovering and the US and China have gained momentum again, we expect the moderation in the euro area to be only temporary. We look for growth to rise to 1.5-2% in H2 and our forecast for 2015 at 1.9% GDP growth is still above consensus at 1.5%. 

Chinese data surprised on the upside again as Flash HSBC PMI for manufacturing climbed to 50.8 in June (consensus 49.7) from 49.4 in May. We look for a slight further increase in the next two months but then expect to see a peak during the autumn as the effect of stimulus measures fade a bit again. 

Broad-based US acceleration after very weak Q1

In the US, Markit PMI for June for both service and manufacturing was very strong, pointing to a further increase in growth momentum. Personal spending growth in May moderated a bit but it comes after a strong rebound going into Q2. Initial jobless claims stayed broadly unchanged at very low levels confirming robust activity and a low lay-off rate in US companies. We also continue to see improvement in investment spending. Core durable goods orders were broadly as expected confirming the stronger trend seen recently. Finally, home sales numbers surprised on the upside as the housing recovery is gaining some strength again. This is well in line with our expectations, that US housing should gain pace again going into H2 as the negative effect of last year’s increase in mortgage yields is fading. 

Looking back at Q1, though, the message was less upbeat. Q1 GDP was revised lower to -2.8%. This was partly due to changes in the healthcare consumption component but net exports also showed a much bigger drag. This is history though and does not provide much information for the future path of US growth where most indicators point to acceleration. 

US inflation picking up further

On the inflation front, the data continued to point to further upward momentum in US core inflation. In line with expectations, the core PCE deflator rose to 1.5% y/y. Looking at the three-month annualised change, it is clear that core inflation pressures have picked up again. This measure stands at 2.1% and thus above the Fed’s target of 2%. So far, Fed chairman Janet Yellen has called the rise in core inflation ‘noise’ and in line with Fed expectations. This is probably why the Fed surprisingly held on to its dovish tone on inflation at the latest meeting. However, as more data points to higher core inflation, the Fed may soon change the tone to less dovish.