GAM's chief economist and head of investment solutions says inflation has been stopped in its tracks.
'During our last asset allocation committee meeting, we noted investors’ diminished enthusiasm for the global reflation theme, which had propelled equity prices and bond yields higher after the US elections.
This month, a subtle but important shift took place as headline and core rates of inflation began to slow – even decline – across major industrialised countries, with the exception of the UK. The change not only reflects economic reality, it is also increasingly the dominant driver of asset prices.
At this month’s meeting, we considered the importance of this shift, accompanied by still reasonable global growth and rising global profits, for our asset allocation decisions.
Just the facts
The shift to stalling or falling rates of inflation is surprising. Nor is that outcome simply due to receding base effects related to energy prices. Across much of the advanced economy complex output gaps are no longer present. In some cases, for instance in Germany or Japan, economies are operating beyond full capacity. Reflecting tighter labour markets, unfilled vacancies reached new highs in the US in April and in Japan are at levels last seen in the early 1970s.
Nevertheless, the Phillips curve – the historically reliable relationship between full employment and accelerating inflation – has all but vanished.
Have the laws of (macro)-economics been repealed? Probably not, but empirical relationships have changed. The causes are too many to elaborate here, but a combination of low inflation expectations, elevated levels of economic, financial and political uncertainty among many in society, and disruptive new technologies have sufficiently repressed the customary relationships between capacity and prices (or wages).
In short, inflation has been stopped in its tracks, at least for now.
Flatter curves, higher markets, greater rotation
What does this imply for markets? Most obviously, yield curves have flattened as bond yields dipped on receding inflation expectations and as US short rates rise in anticipation of monetary policy normalisation. This was reinforced by the Federal Reserve’s recent actions and statements.
Even as bond markets weaken again, yields remain lower than at the end of the first quarter. Crucially, however, lower bond yields do not reflect growth concerns. If that happened, corporate earnings and equity markets would be at considerable risk.
The fact that equities are taking the re-shaping of the yield curve in their stride reflects confidence that low inflation is not a function of weaker growth.
Indeed, despite a slip in growth surprise indices (which largely reflects unrealistic expectations of what US policy under president Donald Trump could deliver), so-called ‘now-casting’ models, as well as of the incoming data, suggest that global growth modestly accelerated in the second quarter from a lack lustre first quarter. And despite a downturn in the global ‘credit impulse’, there are few tangible signs of significant slowing of economic activity in any major economy, barring, perhaps, the UK.
Meanwhile, global equity markets are also supported by rising profits, which are now more geographically widespread than in past years. Much has been written about narrowing US equity leadership, driven by select technology names, but globally equity leadership has more breadth. Europe, parts of the emerging complex and many mid cap names in Japan are contributing, reflecting discernible improvements in global economic and corporate fundamentals.
Who are the key winners and losers?
Among the winners are risk assets generally, including growth and quality styles in equities as well as emerging equities. Lower bond yields and flatter yield curves support barbell equity holdings, namely a combination of stable income (quality stocks) and a preference for growth (tech disruptors).
A big winner is likely to be emerging markets, buttressed by stable growth, rising earnings, attractive relative valuations, lower interest rates and a softer US dollar. For emerging equities, it rarely gets better than that.
Among the losers (in some cases in relative terms only) are value stocks and financials, as well as the dollar, which is handicapped by narrowing long-term interest differentials and equity outflows favouring ‘rest of world’, against the backdrop of a still-sizeable US current account deficit.'
If you would like to take part in the next Investment Committee panel, email Suzie on firstname.lastname@example.org