The return of inflation

In our January semi-annual outlook, we evoked the theme of deflation fears coming to an end. These fears have effectively receded since then. We are now on the verge of reaching a milestone and envisaging forthcoming inflation pressures. Although base effects are clearly providing the initial momentum, some fundamental improvements are also discernible.

Firstly, base effects will cause a rise in observed inflation after the oil price reached its lowest level last January. CPI levels could reach 3% in the US and 1.5% in the Eurozone based on an assumption of oil prices remaining stable at 50 USD.

Some domestic and external pressure can also be observed. In the US, wage trackers have shown some improvement over the past few months. Job-switchers’ wages are increasing by around 4%, not far from pre-crisis levels. However an uptick in labor force utilization is clearly lacking and this factor needs to improve to see a further rise in global wages. Potential use of fiscal easing, which both US candidates intend to deploy, will also add some pressure. From an external perspective, China has recently stopped exporting deflation, while producer prices have just turned positive and public support should allow the CPI to increase more rapidly.

Inflation outlook in the broader economy and among the markets should bottom-out from its record low levels. Given the more stable dollar and with oil prices also stabilising at higher levels, inflation outlook should now improve, as both monetary policy and fiscal policy are geared towards an increase. 

Inflation breakeven has just started to bottom-out in the US and we are expecting a further increase. Flows have recently returned and valuations are attractive. It seems to be an opportune moment to invest in inflation-linked bonds in the US, hedged with US Bonds, in order to capitalise on rising inflation without being impacted by steepening rate pressure.