7 min read 21 Sep 18
Also available in: Español
Summary: After a decade dominated by extraordinary monetary stimulus that has kept interest rates and consumer prices at bay, the dog that didn’t bark is finally showing signs of life: inflation. As seen on the chart, both US and UK wage inflation have spiked in a tightening labour market – an old textbook recipe for further price increases to come. However, one has to look beyond the headlines to depict the real story – which I see as one of goldilocks and the bear.
The US economy continues to enjoy a goldilocks scenario, in which the economy is neither too hot to force a sharp rate tightening cycle, nor too cold to slow down corporate earnings. This backdrop allows companies to borrow at relatively low rates, helping them avoid defaults, at the same time that consumers do not lose too much purchasing power due to inflation. This is the dream scenario for many risk-on assets, such as High Yield, and has fuelled the US stock market to one record high after another. Happy days.
This economic sweet spot, however, could be derailed by the ongoing trade wars, which could well get worse before getting any better. While some forecasters say the trade dispute may lead to a slowdown and therefore, lower inflation, I do not share their view because:
Therefore, I see the Fed continuing to raise rates as planned and despite the recent dovish speech of Fed chair Jerome Powell in Jackson Hole in August.
The bear – UK: The picture is a bit cloudier in Britain, even if wage inflation surprised on the upside in July, reaching annualised growth of 2.9%, matching the March increase, and the highest level in 3 years. As shown on the chart, the optimism around UK inflation is not reflected in the market-implied future inflation rate, expressed by the breakeven rate:
Let’s look beyond the headlines to understand why:
All the above leads me to think that, despite the recent increase in prices, inflation may end the year at the lower end of 2%, a level more reflective of Britain’s true – and more moderate – economic heartbeat. What could potentially challenge my inflation view? Brexit, of course, whose inflation outcomes seem as binary as the opinions that the subject draws. I envisage two scenarios:
Which of these outcomes is more likely, depends on one’s views over Brexit. But, as far as inflation goes, the only thing that seems certain is that while in the US inflation is being generated by economic growth, in the UK it largely depends on the Brexit outcome – in which case, it may well end up being a bear. I hope to be wrong again.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.