15 FEB

2018

A much stronger expansion than expected only a few weeks ago, renewed weakness in the US dollar and rising commodity prices are just some of the many reasons to fear the return of inflation.

After nearly a decade of uninterrupted deflationary surprises, the consensual view of below-trend inflation is getting hit, witness the January CPI data. The first remarks by Fed chair Jerome Powell (the Fed is “in the process of gradually normalizing both interest rate policy and our balance sheet) echoed the last FOMC chaired by Janet Yellen which made it clear that the economy “will warrant further gradual increases in the federal funds rate”. We agree with the Fed that US inflation is likely to move up this year. However, outside the US there are little signs of inflationary pressures. Overall, we expect the investment environment throughout 2018 to remain favourable, thanks to a supportive policy mix and good economic and political visibility.

America first. The US cycle is the most advanced on the global scale – witness the unemployment rate – and the tax reform has injected an additional stimulus, leading perceptions to shift rapidly. Since end-November, US 10y bond yields – led by rising inflation expectations – have risen by 45bp. As a result, US real yields have remained extremely low, at 77bp, which constitutes a strong support for the economy and for equities. The US bond market has finally acknowledged that there is no recession around the corner and quickly adjusted towards the projected path of 3 Fed fund hikes this year. To some extent, rising bond yields are more in sync with rising equity values. Looking forward, we expect further normalisation, but no overshooting yet, as the US 10y bond yield could reach 3% in 2018, as implied by the strength of the expansion.

The inflation situation is very different in the Eurozone, as inflation is likely to converge only very gradually towards the ECB’s 2% goal. Both ECB forecasts and the survey of professional forecasters show that expectations are anchored below 2% until, at least, 2020. The data published for the month of January confirmed the sluggish inflation trend, as the annual rate in consumer prices fell to 1.3% (core CPI at 1.0%). Further, the upward movement in the currency over the past 12 months is easing tensions. As the expansion progresses rapidly at an above-potential rate, we expect the slack in the economy to be removed.

The implications in terms of asset allocation are straightforward. We entered the year with a risk-on stance and a short duration bias. Should we be gearing up for a widespread inflation scare? Clearly, as the global economy has just closed the output gap opened in the aftermath of the Great Financial Crisis, we do not expect tensions in the core CPI to persist. A shock to commodity prices could temporarily produce an upsurge in some prices whereas a trade and currency war could also lead to sustained upward pressure on many prices. This tail risk would leave few assets to hide, such as real assets, volatility and cash (as we would assume a risk-off movement).