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Piecing the growth-inflation puzzle
THE year so far has seen economic activity pick up and growth rebound, though not for the reasons most expected.
In the wake of the US presidential election last November, economic activity took off in the US on the expectation that President Donald Trump would deliver swiftly on pro-growth policies such as tax reforms and infrastructure spending.
After some brief optimism, however, both the Trump administration and the investing public have come to realise the limitations of the president in enacting policy changes. They have also underestimated the time and political capital required to achieve such changes in Washington. But perhaps the real surprise for most investors has been how consumer and business confidence in the US have remained solid despite the dysfunctionality witnessed in Capitol Hill. At the same time, actual economic activity has picked up and despite what was thought to be a seasonality-inspired speed bump in the first quarter, economic growth is expected to remain resilient.
Why is this happening? Well, to put things into perspective, global economic indicators had already pointed to a turnaround prior to Mr Trump's victory. Mr Trump's victory was a dash of kerosene to the fire, rather than the kindling needed to start it. Therefore, even as disappointment with Mr Trump sets in, the underlying economic momentum built up before he was elected continues to drive growth. In addition, other regions such as Europe and China have experienced improving market sentiment and activity with a greater degree of synchronisation than observed since the global financial crisis. The macro environment has become more supportive, with political headwinds blowing over following the French presidential election.
The curious development amid this pick-up in economic momentum is the lacklustre state of inflation. While previous economic cycles have typically seen stronger economic activity lead to higher inflation, this has been largely absent in the current economic cycle.
After a short-lived spurt at the turn of the year, inflation has receded across most major economies including the US, the eurozone, Japan and China. In aggregate, it has receded across emerging economies as well. Forward-looking indicators such as the consumer price index, gross domestic product and unemployment figures also indicate that inflation expectations for G-3 economies of the United States, Japan and Europe have come off the boil since the start of the year.
While it is always difficult to pinpoint the drivers of inflation trends (as there are many interdependent variables that can affect prices), there are a few current suspects. One of them is the stubbornly low wage growth in most developed economies despite tighter labour markets. In the US, for example, the unemployment rate has fallen beneath the lows of the pre-Global Financial Crisis which started in 2008, yet wage growth is nowhere near its pre-crisis pace.
As wage growth in developed economies typically feeds into core inflation, the slow pace of wage growth appears to be contributing to the weak inflation dynamic. A second potential driver is the price of commodities, particularly that of oil. Since peaking early in the year, the year-on-year change in the price of oil has declined steadily, due to a combination of base effects and more recent price declines. For oil-importing economies, this decrease in changes to year-on-year oil price tends to foreshadow lower non-core inflation.
Amid positive growth signals and benign inflation, both equities and fixed income have done well for investors this year. With US monetary policy proceeding along a well-telegraphed path with limited upside risk, emerging market currencies have been attracting carry trade flows as well.
Against this backdrop, an obvious risk on the horizon is for a sharp convergence between growth and inflation trends.
To be clear, a divergence between growth and inflation trends is not uncommon and can persist. Any disruptive impact arises when these trends converge rapidly and unexpectedly, taking market participants by surprise.
In one scenario, growth persists and inflation accelerates. Bond yields are likely to rise quite rapidly, not unlike during the summer of 2013 when the Federal Reserve first mooted tapering its quantitative easing programme.
Higher inflation would push central banks to adopt tighter monetary policy - the Fed may adopt a more aggressive pace of rate hikes and reduce its balance sheet more quickly, and central banks in a number of emerging economies may abbreviate their easing cycles. Should interest rate differentials widen and certain emerging economies' external balances be perceived to deteriorate, emerging market assets may be adversely affected via the exchange rate channel. Those segments of the equity market which have greater pricing power and hence the ability to pass on higher costs to consumers should hold up better in such an environment.
A second convergence scenario involves confidence fading and growth decelerating to match the weak inflation picture. This is a story that has played out a few times in recent years as growth spurts have petered out, leading to a retracement or temporary reversal in the performance of growth-sensitive assets such as cyclical equities whose prices are affected by ups and downs in the overall economy. In a scenario like that, fixed income, in contrast, should perform better for investors.
Between the two scenarios, we think the first is more likely to unfold. The growth trend appears resilient, particularly as it is more synchronised across global economies than in previous years.
Another factor in play is oil. While oil has been weak recently, we are of the view that a positive demand/supply balance will support a recovery in the second half of the year. This is because the production cut agreement between the Organization of the Petroleum Exporting Countries and a number of other oil-exporting nations has reduced global supply even in the face of higher US shale oil production. From this perspective, our asset allocation is tilted in favour of equities, with a preference for those in Europe, Japan and selected emerging markets such as China, India and Indonesia. In the fixed income space, we prefer high yield bonds over investment grade bonds, as the spread provides a buffer against interest rate increases. With high yield bonds, credit selection is key to avoiding credit events in the portfolio.
- The writer is chief investment officer, UOB Private Bank.