Wrong for investors to dismiss inflation threat

EARLIER this year, the big fear was that inflation was going to surge, led by the

US, and that this was going to drive aggressive interest rate hikes by the US Federal Reserve and much higher bond yields, which in turn would pressure other asset classes. Such fears sparked a significant correction in global share markets with US shares falling 10 per cent, global shares falling 9 per cent and Australian shares falling 6 per cent. Since then, inflation fears seem to have taken a back seat. While in most major countries 10-year bond yields are well up from their 2016 multi-decade lows, US bond yields have struggled to stay above 3 per cent, German bond yields are around 0.3 per cent, Japanese bond yields are around 0.09 per cent and Australian bond yields are around 2.58 per cent, with most well below their highs seen earlier this year. So, what happened? Should we still worry about inflation?

What happened?

A whole bunch of things have helped bond yields remain low and kept investors focused elsewhere:

• First, although US inflation has moved up, it remains relatively benign with the core private final consumption deflator around 2 per cent year-on-year which is the Fed's inflation target. It seems that every US jobs report has seen the same "Goldilocks" (not too hot/not too cold) combination of strong jobs growth and falling (now sub-4 per cent) unemployment but low wages growth of around 2.7-2.8 per cent year-on-year implying low inflation pressures.
• While the Fed has continued its drip feed of rate hikes consistent with strong economic conditions, the lack of any inflation break-out has meant that they have been able to remain gradual, with one hike every three months and monetary policy remains very easy.
• Strong US earnings growth has helped distract share market investors. June quarter earnings results saw 84 per cent of companies surprise on the upside regarding earnings and 71 per cent beat revenue expectations, both of which are above normal levels. Reflecting this, June quarter earnings growth has come in around 27 per cent on a year ago, up from expectations for 20 per cent earnings growth in early July.
• The trade war threat has tended to dominate, leading to fears of a hit to global (and US) growth and safe-haven demand for assets such as bonds (which has helped keep their yields down).
• Worries about Italy's new populist government blowing out its budget deficit and already high level of public debt, or worse still threatening to leave the euro resulting in bond holders taking a hit on their investment in Italian bonds, have boosted demand for German bonds, depressing their yields, and helped extend expectations of easier for longer European Central Bank (ECB) monetary policy.
• Other geopolitical events such as the crisis in Turkey have kept investors on edge for deflationary shocks. The latest worries about contagion from Turkey as its currency plunged anew are likely overdone. Yes, there will be some impact on eurozone banks that are exposed to Turkish debt (which will keep the ECB cautious), but it is unlikely to be economically significant. More fundamentally, Turkey is not indicative of the bulk of emerging countries. Its currency has crashed 40 per cent or so this year because of current account and budget deficit blowouts, surging inflation, political interference in its central bank and populist economic mismanagement generally. Emerging markets will remain vulnerable until the US dollar stops rising (as a rising greenback boosts US dollar-denominated debt servicing costs for emerging countries that have high foreign debt), the global trade threat ends and uncertainty regarding Chinese growth fades. And upwards pressure on the US dollar is likely to continue as the Fed is unlikely to stop its process of gradual rate hikes anytime soon.
• Finally, while growth in the US has accelerated this year, in other major countries it looks to have slowed.

Implications - another extension to the cycle?

These considerations have combined to help fade the inflation/Fed tightening fears of earlier this year with the result that bond yields have been contained and most share markets have been able to recover from their February inflation-scare lows. In some ways, it is more of the same because the whole post global financial crisis experience has been one of two or three steps forward towards stronger global growth followed by one or two steps back (with eg the eurozone debt crisis, the 2015 growth scare and various deflation fears along the way). What we have seen this year is effectively a continuation of that.

Delaying or slowing monetary tighteninghas helped to extend the economic and investment cycle. The implications have been:

• A continuation of low returns from cash and low bank deposit rates.
• Yield-sensitive share market-listed investments such as real estate investment trusts have been able to rebound.
• Unlisted assets such as infrastructure and commercial property have continued to benefit from a search for yield by investors.

With global monetary conditions remaining easy and US recession warning indicators still not flashing red (although the yield curve is worth keeping an eye on), our assessment remains that the investment cycle has more upside and that a US recession remains a way off yet. However, the main risks around this relate to the threat of a global trade war should the tariff threat from the US continue to escalate.

Should we still worry about inflation?

It would be wrong for investors to dismiss the inflation threat - particularly in relation to the US:

• First, while it has taken a long time to get there resulting in numerous deflation scares along the way, spare capacity in the US economy has been mostly used up.
• Second, numerous indicators point to a very tight labour market in the US - with more vacancies than there are unemployed, very high hiring and quit rates, companies nominating finding suitable labour as a bigger problem than weak demand - suggesting that sooner or later, wages growth will start to pick up significantly.
• Third, inflation is well known to be a lagging indicator, and it often appears as a problem after the pace of economic growth has peaked.
• Finally, from a longer-term perspective there is a risk that the lessons of the break-out in inflation from the late 1960s into the 1970s are being forgotten, and that populist politicians will seek to weaken the institution of an independent central bank targeting low inflation.

US President Donald Trump's tweets critical of the Fed raising interest rates are of concern in this regard.

• The writer is head of investment strategy and chief economist, AMP Capital