Since 1979, central banks have made concerted efforts to tame inflation across the G10 world. With strength and consistency, they have successfully reduced inflation rates from more than 10%+ p.a. to below 2% today. Mission achieved – but maybe a bit too much. For perhaps the first time in 40 years, inflation is consistently undershooting expectations, and expectations are collapsing. It is all the more puzzling that we are currently late-cycle, a period when central banks are traditionally fighting against inflation, not for it. What explains this current situation in the macro data and what are its implications in terms of market sentiment and valuation? Overall, we think this situation is supportive for carry-yielding assets and strategies. The underlying question is one we have already raised in these weekly updates: are we lost in Japan and how can we adapt our portfolios to this situation? Inflation has fallen short of central bank targets for some time now. Most of them target a 2% long-term inflation goal but since 2016, it has not worked well. In the Eurozone, core inflation (inflation ex cyclical elements) has increased at around 1% p.a. over the period. In the US, things look more encouraging. US core inflation has been hovering around 2% but, when crunching the numbers, a similar situation to the rest of the world appears: a large portion of the current US core inflation rate (2.4%) comes from the cost of health care and the fact that shelter is included. Net of both these sources of inflation, US core inflation falls back to 2.1%: not a high number given the fact that we are late-cycle. A similar case can be made in Canada, Sweden, Norway, Switzerland – and of course Japan. In late-cycle 2006-2007, these numbers were much higher: what is missing today?“Lost in Japan” – Shawn Mendes, 2018
What’s Next?
Macro: The Root of Undershooting Inflation
First things first, economic theory predicts that the longer-run growth rate of prices should be strongly tied to that of wages. What is happening there? In the Eurozone, the growth rate of wages from 2011 to 2018 has been roughly 1.5%: it’s hard to see inflation reaching higher values. This increased recently, with June numbers rising up to 2.7%, pointing to the possibility of stabilising inflation. In the US, wage growth currently sits around 3.5% for now, following the Atlanta Fed survey. This is not low, but is still lower than where we were in 2006-2007 (above 4%). In Canada, wages have been growing by 4.5% since 2017, still lower than the 6% observed in 2006-2007. The wage situation is therefore still supportive of an above 1% inflation across the G10 world, but lower than the previous cycle. This explains only a small portion of the current situation.
The missing piece of the low inflation puzzle is probably to be found elsewhere. Demand since the 2008 crisis has grown at a slower-than-usual pace. According to IMF data, between 2006-2007, the world’s GDP grew by an average rate of 5.5% with investment growing by 10%. Over the recent period, these numbers fell to 3.5% and 7%, respectively: clearly, investment but also consumption has slowed.
This has had two key consequences: first, it has led to a slower growth rate in commodity prices. The seasoned investor will remember when oil peaked in 2007 at above USD 140 per barrel compared to recent highs of just USD 75 per barrel. A similar case can be made with most commodities. They are not included in core inflation, but when prices increase for a long enough period, they eventually contaminate core inflation indices by pushing other products’ prices higher. The second consequence is that, with weaker demand, it becomes harder for companies to flow increased production costs to the consumer. In the US, over the 1990-2006 period, the CPI to PPI ratio grew by 1.2% but, since 2008, this ratio has remained stable: the “pricing power” of companies has clearly collapsed. This roots the lower inflation issue in slow economic growth. However, other structural sources of low inflation should be listed here, such as the impact of an ageing population, the combination of globalisation and deindustrialisation weighing on wages and pricing power, while services are gaining a larger share in the value created at the expense of industry. Recently, our Inflation Nowcasters have been signalling potentially negative inflation surprises. Low inflation situation is therefore an essential element for us now.
Sentiment and Valuation: Be Selective in Your Carry Strategies
From an investment perspective, it is essential to understand how low inflation affects market sentiment and asset valuations. First, in terms of sentiment, we think this low inflation surprise situation means that central banks should lean on the dovish side for longer. The recent moves from both the ECB and the Fed mean, in our view, that sentiment towards carry-related assets and strategies should remain positive. The quest for yield triggered by quantitative easing is here to stay in our view¸ at least in the Eurozone where it should persist for longer. This low inflation situation is likely to maintain an environment for which sentiment towards carry-related assets should remain positive.
Which assets will benefit from this positive sentiment? To answer this question we think comparing carry across risk premia from a cross-sectional (which risk premia yields the highest carry for a given unit of risk) and a time-series perspective (which risk premia yields the highest carry compared to its own history) makes a lot of sense today. Such an analysis finds that both investment grade and high yield credit look attractive today: they deliver an attractive carry while also being potentially the target of a central bank buying frenzy should the macro cycle deteriorate. We also think that carry strategies such as bonds carry and dividend carry are attractive for similar reasons: their carry looks appealing by historical and cross-asset comparison. We think that screening sentiment and valuations (the flip side of the carry coin) is essential to harness the potential impact of the lower inflation situation.
Asset Allocation: Go Carry Go!
Inflation should remain largely under control while showing periods of undershoot. Central banks are worried about the ‘Japanisation’ of their respective economies and they will fight against it using all available tools. In the end, the only mistake Japan made was to hesitate. This, in our view, is likely to bolster sentiment towards carry strategies, especially for the strategies with the highest carry. We are currently overweight investment grade, high yield, bonds carry and dividend carry for these reasons. The fear of getting “lost in Japan” can mean opportunities for investors, but also threats: be selective with the carry you invest in, as they can also become value traps. VIX carry strategies in 2018 were a remarkable example of that. Being dynamic is essential, in our view: we keep a wary eye on both sentiment and valuation to avoid exaggerations.
Lost in Japan
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