Jonathan Baltora: Three devils the detail for inflation investors

Jonathan Baltora: Three devils the detail for inflation investors

Market commentary
04 October 2017

Jonathan Baltora, manager of the AXA WF Inflation Short Duration Bonds, looks at three technical factors driving this year’s ‘inflation surprises’.

Inflation is a simple concept, but there are a number of long term influences investors could consider when seeking to mitigate it’s erosive impacts today. Primary among these are the subtleties of exactly how inflation is measured, as traditional consumer price index (CPI) baskets are attracting increasing criticism for not accurately reflecting shifting consumer spending patterns and price levels. The rise of the digital economy, for example, has provided consumers with infinitely more information, choice and access to goods and services. The underlying technological innovation which has enabled this therefore serves as a deflationary force, thanks to lower barriers to entry, greater competition and price compression. Indeed, the rise of the sharing economy and variable-price services such as Uber will make accurately measuring the price of services increasing challenging.

However, this year’s ‘inflation surprises’ are much more driven by technical factors than these longer-term influences. Below are three more pressing aspects of inflation that warrant closer attention when trying to gauge the future direction of inflation:

1.Wage inflation is stronger than headlines suggest

Despite many market commentators proclaiming the correlation between the employment market and inflation to have declined in recent years, wage inflation remains crucial for investors and central bankers alike when evaluating inflation.

One key measure of this, average hourly earnings, is currently running around 2%. This metric, published by the US Bureau of Labor Statistics on the first Friday of every month, includes the impact of workers entering and leaving the workforce. Given the excess supply in the labour market created by the global financial crisis and its ongoing effects, ‘average hourly earnings’ therefore reflects the wages of individuals who may have joined or rejoined the workforce and accepted lower wages out of necessity in a period of weaker global growth. This translates to only a small or even deflationary wage growth impact in the data.

Another measure however, the Atlanta Fed’s Wage Growth Tracker, is running closer to 3% annual inflation. This compares apples for apples, in that it scrutinises the wage growth of individuals who have remained in the same position within the workforce. Here we see a stronger positive trend, reflecting that there are healthier pockets of wage inflation in the economy than meet the eye. 

2.Short-term effects drive long-term sentiment

Historically, periods of rising inflation have prompted flows into funds perceived to offer inflation indexation, and even short-term inflation moves have been a good indicator of long-term inflation breakevens in the post-Lehman world. This has naturally impacted asset allocation decision-making for investors seeking either to match long-term liabilities or maintain above-inflation growth.

For example, increased investor optimism that the Trump Administration would help lift US – and thus global – inflation coincided with a record level of inflows to European funds – indeed the first three months of 2017 saw the highest quarterly inflow for European-domiciled equity bonds and alterative funds since 2012.

Similarly, we’ve often seen flows into inflation funds when commodity prices nudge higher. Investors can grow excited when oil prices rally, for example, thanks to the immediate impact of lifting the following month’s inflation figures and influencing inflation’s base effect for the following year. This impact is therefore inherently short-term, but has a big effect on sentiment.

But rather than investing in inflation-linked bonds when inflation expectations are rising, investors may find it more prudent to look at when inflation expectations have disappointed (and are therefore likely to rise).

3. Recent US inflation disappointments are likely to be transitory

Despite some solid improvements over the course of 2016, and much post-Trump enthusiasm for inflation expectations, the US Federal Reserve’s 2% inflation target remains elusive. However, investors should be mindful that the Fed uses the core personal consumption expenditures (PCE) inflation metric in this targeting, whereas inflation-linked bonds are indexed to the CPI measure. The PCE measure of US inflation has not reached 2% since 2012 (excluding food and energy costs), and has disappointed more recently.

Ultimately, we believe this disappointment is only transitory, and relates more to one-off factors than structural shifts. Indeed these one-offs – such as wireless telephone services alone pulling down core US CPI 0.25% from March to June of this year – have pulled core US inflation below euro area inflation. However, the impact of these factors will fall out of the annual inflation data towards the middle of 2018, allowing investors to differentiate short-term influences from longer-term trends. Given this, we believe that inflation will continue to normalise as the US output gap gradually closes.

Overall the market remains pessimistic on future inflation, but we must remember that this view has been formed over a long period of time. The ‘normalisation’ we are beginning to see represents an increase from a persistently subdued level – so however incremental the transition, even ‘normal’ inflation will mean a lot to investors.



Notes to Editors

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