In the old Columbo TV show, every episode was the same. The murderer would put together a convincing story about what happened the night of the killing. It would appear as though he had fooled the poor modest detective Columbo. But then Columbo would point out a single detail and the whole story would collapse. The murderer would then have no choice but to confess. 1 1 Close Never heard of Columbo? You must be under 70 years old. If you look at the current market narrative it seems like the classic so-called “late cycle” story. The economy is strong, unemployment is low, and the Fed is hiking. Stocks have been in a long bull market, but investors are getting nervous about the economy overheating. It all sounds perfect, but then you can hear Columbo saying, “there’s just one thing…” It’s inflation. 2 2 Close By inflation we mean the overall price level. This can be hard to measure, but it is a meaningful concept.
Despite the strong economy and allegedly tight labor market, core CPI inflation has been falling on a year-on-year basis in the past few months. 3 3 Close Core CPI inflation has fallen from 2.4% in July 2018 to 2.2% in September 2018. Source: Bureau of Labor Statistics. The core PCE measure, which is followed closely by the Fed, is around 2% after breaching the target level for the first time since 2011-2012. 4 4 Close Core PCE inflation was 2.0% YoY as of August 2018. Source: Bureau of Economic Analysis. While there is some inflation, it is moderate and at least for now is not threatening to get out of control. As we argued a few weeks ago, inflation hasn’t been driving the rise in bond yields, but that does not lessen the importance of inflation to investors. Despite what you might hear, it is still one of the biggest threats to asset prices.
Economists and investors are often overly reductionist in their understanding of inflation. They try to come up with grand theories of inflation based on one factor or another. Unfortunately, inflation has many causes and has proven surprisingly slippery for theorists. It’s tempting to draw lessons from the famous cases of hyperinflation and find scary similarities to the current situation, but these analogies are not particularly useful. For hyperinflation to occur, the currency of a country must become (almost) worthless. This doesn’t happen because a central bank leaves rates too low or because of an incremental change in tax policy. Rather, it is usually the result of a complete breakdown of the economic or political system. It can follow defeat in a war or the collapse of the largest sector of the economy. 5 5 Close For example, an economy is driven by agriculture and the farms stop growing anything. Of course, no country is immune to disaster, but hyperinflation is not something you can forecast by looking at the details of a CPI number. You’ll know it when you see it. 6 6 Close One famous economist has suggested that hyperinflation is first and foremost a political phenomenon. I think this is mostly true, although you could imagine something like a natural disaster causing it as well.
Others look at demographics as a cause of inflation. Younger countries seem to have higher inflation than aging ones. This may seem counterintuitive because older people tend to spend money and not work. 7 7 Close And they also watch Columbo. That should lead to more people chasing fewer goods, which would be inflationary. However, with age comes less demand for investment. Even though savings goes down, there is less need to move resources into projects for the future, so older countries may actually have too much production capacity rather than too little. In younger countries, there is a greater need for capital and labor to be used to prepare for later consumption. Also, younger countries have a lot of children who don’t work and, as all parents know, consume a lot.
In the developed world, demographics seem to be working against inflation. Japan is the most famous example, but other countries in Europe and North America may be following that path. However, demographics, while a factor, do not always drive inflation. Post-communist Eastern Europe experienced high inflation despite aging populations in many of the countries, though this has reversed in recent years. 8 8 Close The causes were probably a combination of political upheaval and a change in consumption patterns that led to an increased demand for investment. Basically the former communist countries did not have the proper production base to accommodate the new capitalist demand.
What we tend to see in developed markets is cyclical inflation. When the economy is strong, inflation rises, simply because there is more demand for goods and services. Wages rise as companies need more employees to meet the increased demand. This cyclical inflation reverses when then economy turns bad, and demand falls. Companies are stuck with inventories of goods and excessive workers, which they have to work off. Wages stop rising and prices go down.
According to many economists, as long as people don’t expect prices to keep rising, cyclical inflation won’t turn into more entrenched inflation. Central banks like to pat themselves on the back for their role in keeping these so-called “inflation expectations” stable with their “credible” policy, but other conditions play a role. If companies have more power in wage negotiations and labor markets are more flexible, it will put downward pressure on wages and prices. Free trade of goods helps keeps inflation down because it increases competitiveness, which can prevent price increases. 9 9 Close A cynic might argue it adds to the pool of inexpensive labor. When these and other factors exist, cyclical inflation can remain contained and not lead to the spiral of higher entrenched inflation.
Recent reports show that tariffs are increasing costs for manufacturers and some folks fear this will be passed on to consumers. This is not unreasonable to expect, but it is important to put it in context. A single tariff, or even a set of tariffs, can lead to short-term inflation, but it would take a real disruption in trade for this to become entrenched. The trade negotiations will be more important than the incoming price data in determining whether that happens.
What this brief discussion on inflation means for markets is that there is some good news and some bad news. 10 10 Close Yes, this was a discussion on inflation without mentioning the Phillips curve or money supply. The omissions were intentional. The signs of cyclical inflation will probably continue, but there is little reason it will be anything more than that. But the bad news is that if inflation does seem like it is becoming entrenched, it will be a big threat to asset prices. In the past few weeks we’ve seen how sensitive asset prices can be to increases in real rates. One of the nice things about a fall in asset prices caused by higher rate expectations is that there is a built in stabilizer. If asset prices fall significantly, rates will probably start to come back down. Then asset prices can go up again. This process may take a while but it gives the market some comfort. If there is high inflation, rates may not come down even after a fall in asset prices. The fear of inflation and a vigilant Fed might keep rates elevated. It’s a good thing that most of the clues detective Columbo could find in the current economy point to mild, cyclical inflation. We’re still missing that one thing.
What We Are Watching
Brazil Election, Second Round (Sunday) Because no candidate received a majority in the first round of presidential voting three weeks ago, a second round will take place this Sunday, October 28th. The first round resulted in much stronger than expected support for PSL candidate Jair Bolsonaro, who came close to winning 50% of the vote and avoiding a second round. In recent weeks, major polls have shown Bolsonaro winning comfortably against his second round opponent Fernando Haddad. Investors have been optimistic about Bolsonaro’s economic policy platform, driving the Brazilian currency (the real) and local equities to outperform against other emerging markets since the first round. In the unlikely event that polls are way off the mark and Bolsonaro loses, it could generate a severe negative reaction in Brazilian markets.
Eurozone GDP (Tuesday) Eurozone growth slowed in the first half of 2018 and both surveys and government data series point to further deceleration in the third quarter. Uncertainty over U.S. trade policy and a continued lack of progress towards a deal on the U.K. exit from the E.U. may be weighing on business sentiment. Growth in the quarter may also have been negatively impacted by a change to E.U. emissions standards, which led to disruptions in the auto sector. While policymakers at the European Central Bank (ECB) have continued to express optimism on the economic outlook in the eurozone, a weaker than expected result for third quarter GDP could put downward pressure on the central bank’s growth forecasts. If worsening growth numbers prompts more cautious guidance form the ECB on the outlook for policy normalization, it could weigh on the euro while boosting eurozone fixed income markets.
U.S. Employment Cost Index (Wednesday) and Monthly Employment Report (Friday) As the U.S. enters a tenth year of economic expansion, unemployment has fallen to a multi-decade low. An increasingly tight labor market appears to be generating a long-awaited pickup in wages after years of lackluster growth. This week will feature updated readings on two of the most widely followed gauges of wage growth: the Employment Cost Index (ECI) and Average Hourly Earnings (AHE). The ECI is viewed by many economists as the best measure of growth in employee compensation, as it captures changes in both wages and benefits and adjusts for shifts in the composition of the workforce. AHE data does not include benefits and does not adjust for these shifts, but receives considerable attention from market participants because of its timely availability as part of the monthly employment report (the ECI is published only once per quarter). Both series have shown broadly consistent trends over the last few years, accelerating from a roughly 2% trend in the early years of the recovery to readings above 2.5% over the last few quarters. Should the third quarter edition of the ECI and the October data for AHE show a continuation or acceleration of this upward trend, it may mean that a tight labor market could start to put upward pressure on inflation and downward pressure on margins.