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Is the economy too hot, too cold or just right?
WHY has inflation not picked up despite falling unemployment in the US? Is the reflation trade over? Why have global markets ignored this?
Firstly, year-to-date global growth has rebounded with upward revisions to both year-to-date global GDP and global earnings estimates. Normally, analysts overestimate these figures at the beginning of the year and downgrade them as the year progresses (2013-2016) (Chart 1). Crucially, this year the porridge is finally warm, not lukewarm, as a global synchronised recovery is broadening beyond the US to Europe and Asia, boosting global stock markets. In fact, European GDP growth was higher than that in the US in the first quarter for the first time in years.
Conundrum #1: All this makes sense but with one important conundrum; why has inflation in the US not picked up as it approaches full employment? As expected, unemployment continued to decline from 4.7 per cent to 4.3 per cent this year. However, core PCE (personal consumption expenditures), the Fed's preferred gauge of inflation has gone down, not up, year to date.
One reason is the one-off base effects of falling oil and other prices in the measure including mobile phone pricing declining. However inflation, at this point of the cycle, has not rebounded as observed historically. (Chart 2) Is the Phillips Curve broken? The inverse relationship with unemployment and inflation, or has it gone flat?
Clearly, there could be reasons why "full employment" or the absolute level of natural unemployment has fallen, before inflation rises: more labour slack than in official statistics, ageing population, and technology creating deflation in wages. Perhaps the porridge is hotter than it looks? Echoes of the 1960s, an era where ultra-low rates and rising equity markets were prevalent until unemployment went below 4 per cent, at which point core CPI inflation increased from below 2 per cent similar to now, before hitting nearly 4 per cent in just one year.
Make no mistake, this is the No 1 debate at the Fed. If it waits too long to raise rates, the overall inflation would have risen too much and then it will need to hike rates more than expected, disrupting markets.
Basically, Goldilocks for markets continues to be extended for bond and equity markets as the economy is not too hot or too cold, it's "just right".
However, one day, this could change if inflation increases just as the market becomes more complacent on rate rises. For example, the current expectations are for less than one Fed rate hike over the next 12 months and just 35 bps over the next two years.
The other argument is the Fed might be making a policy error with inflation below their 2 per cent target by raising interest rates and tightening financial conditions excessively. The bond market could be pricing this in already with the government bond yields falling and the yield curve flattening. In this case, is the Federal Reserve the bear that steals the market's porridge?
Conundrum #2: Complicating this dilemma, the biggest irony is whether the Fed has actually eased financial conditions by raising rates. Financial conditions are near their easiest since 2009 even after four rate hikes as evidenced by falling bond yields and credit spreads, record high levels in stock markets, and a weaker dollar.
In fact, the Federal Reserve has inadvertently given a double portion of porridge! This liquidity needs to find a home, boosting flows into global stock and bond markets.
In that regard, the easing of financial conditions is actually roughly equivalent to a quarter point cut in interest rates. Importantly, the easing of financial conditions are more than making up for any slippage in President Donald Trump's fiscal policy agenda.
This is the dilemma faced by the Fed should it wait too long to raise rates while waiting to hit its inflation target, which has disappointed the last few months.
Hence, the Federal Reserve's vigilance in the last meeting where it viewed the inflation disappointment as transitory. We forecast one more rate rise this year. The market is pricing in only one rate rise over the next two years. Too complacent in our view unless growth disappoints.
So with all the uncertainty in the world why has global volatility remained so low?
Synchronised global growth and better earnings have helped. Central banks remain accommodative overall with the ECB and BOJ still expanding their balance sheets. It is important to note that political uncertainty is not resulting in economic uncertainty. Clearly, the fears over an EU break up and the US protectionism concerns have declined year to date.
As a result, volatility has plunged across bonds, equities, and foreign exchange.
What are the surprises for 2017 compared to the beginning of the year? Most investors turned bearish on Asian equities due to worries over trade tariffs and protectionism post Mr Trump's election.
Asian equities experienced heavy outflows on the back of this, creating an opportunity. A major theme we identified was "Chindia" for 2017. China was experiencing an economic rebound; it had lowered its exposure to the US with gross exports less than 5 per cent of GDP, and traded at attractive valuations - a "value" story.
India was a domestically driven reform story with the highest GDP estimates among any major country in the world - a "growth" story. In particular, both China and India are up more than some 20 per cent in US dollar terms year to date.
One other contrarian pick was our "overweight" call on European equities. Many had underweighted the region due to political fears and lagging growth compared to the US. In 2017 due to superior European GDP growth relative to the US, robust earnings growth, and strong inflows, Europe is the best-performing major developed market.
In conclusion, central bank policy now will likely become less accommodative than priced by markets with implications for bonds and the dollar.
In addition, equity markets have front-end loaded returns as well due to strong earnings and GDP growth upgrades. We are "neutral" equities in the short-term, after taking profit earlier in the year. We remain "overweight" medium term versus bonds. Volatility should rebound as well, creating opportunities.
Embrace Goldilocks and the Bear if he comes.
- The writer is chief investment officer, Asia BNP Paribas Wealth Management.