Relaxed about inflation?

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– We have taken a little risk off the table after a strong run, and as central bank policy shifts.

– We expect market and central bank inflation forecasts to converge, with the year ending on “3-10-60”: US Treasury yields around 3%, a return of 10% from developed equities, and the oil price nudging USD60/bbl.

– Longer term, we remain positive on growth assets, fuelled by low macro volatility and economic growth close to potential.

Overview

After a strong performance from most assets, investors should not expect more by year-end. Central banks have expressed a clear intent to shrink balance sheets, and we believe the combination of reduced liquidity and crowded trades warrants caution.

In particular, we think reflation risk is mispriced, and expect market and central bank forecasts to converge. We expect the year to end on “3-10-60”: US 10-year bonds around 3%, a return of 10% from developed equities, and oil prices hitting USD60/bbl.

Longer-term, we remain bullish. To paraphrase Daft Punk, the closer global growth gets to its long-term non-inflationary potential, the lower the risk of economic shock, the longer central banks can stay behind the curve and the higher growth assets can go.

These themes are the main drivers of our dynamic investment view.

We are positive on real assets such as inflation break-evens, commodities and developed equities, able to benefit from stable and synchronised global growth.

commodities

We are cautious on credit given the tight yield spread, government bonds and emerging assets as central banks embark on a normalisation cycle.

Unigestion’s World Growth nowcasters

Unigestion’s World Growth nowcasters

Source: Unigestion, as at July 2017. For more on nowcasters, see Introduction to Unigestion’s nowcaster indicators on our website.

Unigestion’s World Inflation nowcaster

Source: Unigestion, as at July 2017. For more on nowcasters, see Introduction to Unigestion’s nowcaster indicators on our website.

 

The resurgence of reflation risk

The first six months of the year have been characterised by an unwinding of the reflation trade, strong performance from risk assets and low volatility. Sharpe ratios are remarkably high – but we don’t think this is sustainable.

Inflation expectations have declined since the Federal Reserve raised short-term interest rates in March this year.

Both nominal and break-even inflation rates lost ground in the aftermath of the meeting. The surge in inflation expectations last summer had already been tamed by December’s interest-rate rise, and it is clear that the Federal Reserve is no longer behind the curve.

Another factor in declining inflation expectations has been a 25% drop in oil prices since the end of February. Commodity markets remain under pressure, with supply generally higher than demand at the present time.

Inflation expectations are moderating

Source: Bloomberg, as at July 2017. Unigestion’s calculations.

Against this backdrop, risk assets have performed remarkably well, led by growth assets. Developed equity markets have gained more than 10%, with emerging equities delivering stronger returns again. Emerging local currency debt has also been a good performer, while credit spreads have tightened across the board. In this environment, carry strategies have delivered returns not seen since the financial crisis.

The strong performance from growth assets can be seen in the following chart, which illustrates the relative performance of our growth, recession, inflation and market stress baskets since the end of last year.

Strong performance from our “growth” basket

Source: Bloomberg, as at July 2017. Unigestion’s calculations.

The third feature of markets so far this year has been remarkably low levels of volatility. The pricing of risk has rarely been as low as it is today.

This trend can be explained by several factors. Some are cyclical, such as low volatility in macroeconomic data due to the accommodative monetary policy and stable and synchronised global growth. Others are more structural, such as the market structure of the volatility market, where the expensive cost of hedging has tempted investors to sell volatility to receive the carry from the VIX curve.

Unigestion’s Market Stress nowcaster

Source: Unigestion, as at July 2017.

Taken together, risk assets have generated remarkably high Sharpe ratios this year of 3.1 for the MSCI World and 3.5 for the MSCI Emerging Markets Index on an annualised basis. Attractive as these appear to be, our assessment is that these are not sustainable from here.

 

A very different second half

We expect reflation to come back under the spotlight in the run up to year-end as steady growth, continued demand, a higher oil price and new policies put pressure on inflation. We don’t envisage a strong upsurge, but with valuations where they are, even a modest increase could surprise investors.

One of the factors that make markets particularly vulnerable as we head into the second half of the year is the concentration of portfolio investments in a relatively small number of positions. The emerging market carry trade, the technology sector and European credit spreads are all relatively crowded trades today.

At the same time, many of the world’s central bankers have expressed their intention to start shrinking their balance sheets. The Bank for International Settlements, in many ways the “bank for central banks”, recently issued a warning about the risk to central bank capital from leverage and the potential asset bubbles being created.

Against this backdrop, inflationary pressures, once properly aggregated, are still solid. We aren’t anywhere near the levels seen in 2007, but our World Inflation nowcaster (on the first page), shows that the risk of deflation is behind us. More than that, we see signs of firmer wage growth across the US, the Eurozone and other developed economies. Even Japan, to some extent, is seeing slightly better inflation data.

Changes in the World Inflation nowcaster in June

Changes in the world inflation nowcaster in June

Source: Unigestion, July 2017

When we look at what could trigger a repricing of inflation risk, it’s not economic growth. Synchronised growth is still with us, even if the pace has moderated. There remain issues in China, where the authorities are endeavouring to slow the housing market with higher interest rates. Overall, however, recession risk has rarely been so low over the past 20 years.

Global demand, on the other hand, remains resilient. For inflation to rise we will need demand to overwhelm production capacities and trigger price rises for goods, wage rises for employees and higher commodity prices. It’s possible that we will see an increase here, and have already started to see firmer wage growth.

We expect to see a reduction in the oil supply as shale oil producers respond to the lower oil price and very flat futures curve by reducing the number of new wells. There is commonly a four-to-six month lag between seeing a lower oil price and a reduction in supply, which triggers higher oil prices and could well feed through into inflation.

Changes in the oil price and rig counts

Source: Unigestion, July 2017

Finally, policy shifts could easily trigger inflation. In the US, the Trump administration has disappointed the market by failing to deliver lower taxes, let alone fiscal reform. A surprise tax reduction could lead to a rapid re-pricing of the inflation premium. Meanwhile, the European Central Bank stands a good chance of being behind the curve. We think this is an intentional reaction to the fear of deflation. Both elements, taken together, should sustain inflation until year-end.

 

The potential for policy error

While we don’t expect strong inflation in the near future, we do expect something of a normalisation. Even inflation of around 2% for the US and 1.6% for the Eurozone would surprise markets today. Another, perhaps overlooked, risk is policy error.

In the US, first quarter GDP expanded at an annual rate of 1.2%, and there is a chance that if the second quarter is no better, Janet Yellen will have to postpone her hiking agenda. How far could the Federal Reserve go without actually derailing inflation or growth?

One way to look at it is to compare the Federal Funds rate and the Taylor rule. The version we use here is the Mankiw variant, which combines inflation, the output gap and unemployment into a level for short-term interest rates which has a neutral impact on the economy.

At current levels, our analysis suggests that this would be 2.25%. It would therefore take four more interest-rate rises before tightening by the Federal Reserve started to weigh on the US economy, assuming no changes to the balance sheet. There seems to be room for inflation expectations to rise again before the Federal Reserve has to take this seriously.

The Taylor-Mankiw rule and Fed Fund rates

the Taylor-Mankiw rule and Fed Fund rates

Source: Unigestion, July 2017

Risks to our scenario include a continuation of the oil bear market, and a slow-down in China. Should those risks materialise, markets could be profoundly shaken as current volatility is making new lows by the day.

Macro volatility shows an obvious correlation to the long-term level of growth, and with the level of economic growth relatively modest, a reduction is unsurprising. Still, an environment where volatility is low has increased the number of possible positions for market participants who are looking for a constant risk exposure. Any volatility which prompts significant unwinding from these investors would be likely to weigh on markets all the more, and another reason for a degree of caution in our view.

 

Important information

This document is addressed to professional investors, as described in the MiFID directive and has therefore not been adapted to retail clients.

It is a promotional statement of our investment philosophy and services. It constitutes neither investment advice nor an offer or solicitation to subscribe in the strategies or in the investment vehicles it refers to. Some of the investment strategies described or alluded to herein may be construed as high risk and not readily realisable investments, which may experience substantial and sudden losses including total loss of investment.

These are not suitable for all types of investors. The views expressed in this document do not purport to be a complete description of the securities, markets and developments referred to in it. To the extent that this report contains statements about the future, such statements are forward-looking and subject to a number of risks and uncertainties, including, but not limited to, the impact of competitive products, market acceptance risks and other risks. Data and graphical information herein are for information only. No separate verification has been made as to the accuracy or completeness of these data which may have been derived from third party sources, such as fund managers, administrators, custodians and other third party sources. As a result, no representation or warranty, express or implied, is or will be made by Unigestion as regards the information contained herein and no responsibility or liability is or will be accepted.

All information provided here is subject to change without notice. It should only be considered current as of the date of publication without regard to the date on which you may access the information.

Past performance is not a guide to future performance. You should remember that the value of investments and the income from them may fall as well as rise and are not guaranteed. Rates of exchange may cause the value of investments to go up or down. An investment with Unigestion, like all investments, contains risks, including total loss for the investor.

Complied: 18 July 2017

 

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