• Dirk Steinhoff, Chief Investment Officer

Special Feature: Are Investors’ Inflation Fears Justified?

For the better part of the last decade, a common concern on investors’ minds was that inflation remained too low. Now, however, they worry about signs that the opposite might soon be the case. Since February, inflation returned to the headlines, as reports from the US on wage gains and consumer prices showed higher than expected increases.

Wages rose by 2.9%, beating analysts’ expectations of 2.6%, while consumer prices increased by 2.1% year-on-year in January of 2018, above market expectations of 1.9%. Following these reports, US equity markets reacted with a fierce selloff, as fears mounted about the possibility of rising inflation that might put an end to the favorable low interest rate environment that market participants have been accustomed to.

A closer look

In order to properly analyze and weigh the risk that the recent developments could bring to the markets, one needs to examine inflation in its appropriate context. To begin with, it is important to understand and to differentiate between the various ways to measure inflation.

The most commonly mentioned and the one we will mostly examine in this article is consumer price inflation. It is measured by the Consumer Price Index (CPI) and it refers to price changes of goods and services from the consumer’s point of view. Various CPI sub-indices calculate these changes in different categories of goods and services, while a commonly used variant, “core CPI”, excludes components that can exhibit high volatility from month to month, like food and energy.

Another similar and widely followed measure is the Personal Consumption Expenditures price index (PCE) and its own sub-indices, which the Federal Reserve refers to when setting its inflation targets (Core PCE). Both measures are closely correlated and follow broadly similar trends, but they are not identical, as the CPI generally tends to report somewhat higher inflation numbers.

A second way to measure inflation is the Producer Price Index (PPI), which tracks the changes in selling prices by domestic producers of goods and services. A third way is asset-price inflation and it refers to a nominal rise or fall in the prices of stocks, bonds, derivatives, real estate and other asset classes. Whereas higher numbers in the CPI and PPI are seen as “bad” inflation, higher numbers in the asset price inflation are seen as “good” inflation.

Traditionally, higher inflation is generally connected to either demand growing faster than supply, or business’ costs going up. But there are many other factors that can have a significant effect. Demographics, central bank policies, increasing productivity through technological innovations or industrial automation, the growth of the online retail sector, all have an impact on price changes. However, one of the most decisive factors has historically been globalization.

The trend towards more extensive and comprehensive international integration of labor and financial markets, especially after its dramatic acceleration since the early 90s, has drastically pushed prices downwards. Following the collapse of the Soviet Union, China, as well as India, and ex-Soviet bloc countries all entered the global economy, almost doubling the size of the global labor pool from approximately 1.46 billion workers to 2.93 billion, according to data from the International Labor Organization (ILO). With the weakened bargaining power of labor, increased competition, economies of scale and the removal of tariffs and barriers, the effect of the globalized economy has played a key deflationary role.

Why investors fear inflation

While anemic consumer price inflation can be a sign of a weak economy, which was one of the reasons that made investors worry over the low levels of the previous years, a return to what is perceived as a “healthy” pace has now given rise to a different set of concerns. Higher inflation numbers can erode investors’ returns, but they also signal a return to a solid economy and can force the central banks’ hand to tighten the money supply. One way of doing so would be to increase interest rates.

In recent years, investors have been increasingly encouraged by positive economic fundamentals both in the US and the Eurozone, like falling unemployment and stronger company earnings, while at the same time they have still been enjoying the benefits of the policies set to fight the previous recession. By pushing and holding rates down to zero and negative levels to control the damage and aftermath of the 2008 crisis, central banks have made a generous contribution to the spike in the asset price inflation we have witnessed over the last years, with the US stock market being one of the best examples.

However, the Fed and the ECB have made it clear that they intend to move towards normalization. While the ECB has been postponing this move, the US central bank has taken more decisive action with a gradual increase in interest rates and the commencement of its quantitative tightening program.

So far, the early stages of the reversal of this long-term policy trend did not have the negative impact on the markets that many had feared. However, its implementation in the US has hitherto been cautious and restrained. The concern now is whether expectations of rising consumer price inflation might expedite rate hikes, causing the economy to slow down and perhaps even triggering a major stock market correction.

The bigger picture

Despite the nervousness over the recent consumer price inflation numbers from the US, it is important to remember that the inflation rate has actually been, and remains, on a long-term downtrend for the last 40 years. Its last peak was during the “Great Inflation” of the late 70s, reaching almost 15% in 1980, and presenting a very real threat to the economy at the time. Gold, traditionally seen as an inflation hedge, skyrocketed from $380/oz. in November 1979 to a then-record $850 in January 1980.

Since then, investors, businesses and consumers alike have remained fearful of consumer price inflation, which might go some way into explaining the wide coverage that the recent US wage and CPI reports received. However, when one considers past patterns and ranges, a relatively small CPI uptick hardly suffices as evidence of an upcoming inflation wave.

As for the rest of the world’s large economies, many face the opposite problem, of stubbornly low consumer price inflation. According to the most recent data from the corresponding national economic statistics authorities, the Eurozone’s inflation rate slowed down to a 14-month low at 1.2%, China’s and Switzerland’s to a 6-month low at 1.5% and 0.6% respectively, while Russia’s inflation rate remained stuck at 2.2%, its lowest point since 1991.

Sweden’s central bank is also struggling with a below-target inflation rate of 1.6%, a major hurdle in normalizing the aggressive policies of the past years and raising its negative interest rates. In fact, the latest figures from the OECD showed that the annual rate of inflation dropped to 2.2% in January from 2.3% in December across its 35 members.

What lies ahead

Even though further moderate increases in consumer price inflation would not be surprising in the short run, the fear of it spiraling out of control appears to be rather overblown. A reasonable increase in inflation is a normal observation in growing economies and if anything, it was its absence that was until recently surprising. Also, the magnitude of the recent CPI figures in the US remains in line with historical recovery patterns and expectations for this stage of the business cycle. In other words, this is what normalization looks like.

As the global economy continues on its growth path, as recent forecasts by the OECD and the World Bank show, and as Central Banks are cautiously beginning to rein in the accommodating policies of the last decade, we can expect to see higher inflation numbers and higher rates, as the “new normal” in the next phase of the economy. However, both will likely still remain low in a historical context.

The deflationary forces that have kept prices in check in the past years are still in place. This includes globalization, despite the current political sentiment and resulting pullback attempts. We see the current negative backlash as temporary and insufficient to impact the trend towards an increasingly interconnected world and globalized economy. That being said, national policies can still have an impact. It is therefore essential to monitor relevant developments on this front, such as the trend to nationalism and populism that can be seen globally or to protectionism like the new tariffs on aluminum and steel recently announced by the Trump administration.

Overall, in the short-run, higher inflation and the subsequent interest rate hikes might hold back and could even trigger a larger correction in the stock market. Nevertheless, the current positive global economic momentum will help to drive corporate profit growth and provide support for the stock markets.