Inflation Is The Genie In The Bottle
Investors have come into 2020 with a relaxed mindset, comfortable that the key fundamentals are stable across major markets. Key global risks that plagued investors throughout 2019 have either receded or been resolved. These include: US/China trade, UK Brexit, Iran/US military action and Hong Kong protests. Policy settings are also very stimulatory, not restrictive.
Simmering in the background, however, is inflation. As the below chart shows, US inflation is above its target. This fact is not widely appreciated. The US Federal Reserve has repeatedly stated it is comfortable for inflation to be above its target band due to the recent prolonged period of undershooting, plus the lack of tools available to combat deflation..
Delving into the detail shows that inflation pressures are mounting. The number of components in the US CPI that are rising leapt up in 2018 and have been trending up subsequently. Signs of this were evident on our recent overseas research trips, particularly in restaurants, office floor space, and across discretionary spending more broadly.
As has been widely documented, the US has a full labour market and wage pressures are rising, albeit not as fast as in prior cycles. The rationale behind this sluggish wage growth has been disruption across multiple industries – and we have written at length about this in the past. Looking at wage data in detail shows that the greatest wage inflation is now occurring in the disrupted sectors. This is highlighting how late the US economy is in the business cycle, as even the disrupted sectors are having to pay higher wages in order to retain their existing workforce.
Despite official inflation being above its target and widespread evidence of rising prices, inflation expectations as measured by the 5yr5yr forward swap rate are currently unresponsive. At some stage investors will need to reprice assets for inflation, with resulting adverse consequences for the bond market. For now, enjoy the calm before the volatility storm.
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