MITON’S DAVID JANE: INFLATION INFLATING?

• Inflation could rise more rapidly than expected and cause an interest rate shock
• Inflation will more often surprise to the upside
• Disinflation drivers make better narrative stories than real economic sense

David Jane, manager of Miton’s multi-asset fund range, comments:

“2018 has continued where 2017 left off with strong rises in global equity markets, the UK excepted, and a healthy corporate bond market, at least in terms of new issues. The only cloud on the horizon appears to be the prospect of rising bond yields and interest rates as inflation creeps back into the system.

“Against this seemingly bullish background, it pays to consider what might go wrong. Among the more likely scenarios at present is that inflation rises much more rapidly than is currently considered likely. Following 30 years of disinflation, the greatest majority of observers seem to believe that inflation is beaten and if it returns at all it will be only temporary. It was this environment that led to the huge 30-year decline in government bond yields. Some commentators now suggest that this very long-term trend is coming to an end or has indeed already finished. We would broadly concur with that view, although such a long-term trend will not reverse instantly.

“The reasons given for the disinflationary period vary and tend to reflect the view point of the commentator as much as any real understanding. Economics is far from scientific. For a long time, the most popular theory was central bank prudence and independence. During the rise, monetarist economics inflation targeting became a popular central banking approach and many central banks were freed from government interference to focus on reducing the dreaded inflation.

“Obviously it’s natural for central bankers to presume they were successful for what they did, not for when they were working, so for many years the falling long term inflation rate was presumed to be because central bankers were now more sophisticated and successful in their policy implementation. This viewpoint is not consistent with the post financial crisis era, where interest rates have been low or even negative, a huge amount of money has been created and still inflation hasn’t returned to any meaningful degree. Therefore, other explanations have become popular more recently.

“A much more credible explanation is the rise of China. The introduction of a huge new workforce to the world economy in China clearly led to a massive reduction in wage pressures worldwide. Numerous data points exist which suggest that outside those highly specialised roles, who could sell their skills to a greatly expanded global marketplace, more mainstream workers struggled to achieve any growth in their earnings as they compete with a much larger global workforce. This condition no longer exists, China’s working age population is now expected to decline and there are no obvious huge untapped work forces about to join the world economy on the horizon.

“A related factor was globalisation, the rise of China coincided with a material reduction in the barriers to global trade, via China joining the WTO and a generally supportive political environment worldwide for free trade. Not often talked about was the reduction in technical barriers to trade such, as the introduction of containerised shipping, which led to a huge fall in the logistical costs of long distance trade.

“It’s quite clear that the political environment, at least in the West, is no longer as supportive of free trade, and the US is by far the biggest market for traded goods. China’s One Belt One Road strategy may lead to the opening up of trade in the Central Asian region through to Europe and reduce the cost of transport throughout the region, but this is unlikely to be as deflationary as the growth of US/China trade from 1980 onwards.

“Technology also plays a part.  Perhaps better communication (the rise of the smartphone and the internet) has led to greater price competition due to the reduction in barriers to price discovery. Or maybe consumers are spending more of their incomes on less resource intensive products, experiences rather than physical goods. Or maybe the products consumers now buy have vastly greater economies of scale (obviously an app can be downloaded at miniscule marginal cost) making increased demand less inflationary.

“These arguments all make much better narrative stories than they do real economic sense when you consider that the size of the economy is the sum of all its inputs. Broadly, improvements in productivity such as these lead to increased incomes to be spent elsewhere.

“It seems that none of the factors which gave rise to the broadly disinflationary era apply anymore, which doesn’t mean we are necessarily in an inflationary era but other things being equal the future is as likely to be one of rising inflation as falling inflation.

“In the near term, are we likely to see an upside surprise in the inflation data, leading to an interest rate shock? Quite possibly, labour markets are tight, the oversupply of natural resources seems to be much reduced and OPEC appears to be determined to not allow material falls in the oil price. To us, the balance is that inflation will more often surprise to the upside than the downside compared to the past. Therefore, our preference is for assets that have defensiveness against rising interest rates and benefit from inflation, compared to what has recently been regarded as defensive, such as beneficiaries of falling interest rates with strong pricing power.”

• Inflation could rise more rapidly than expected and cause an interest rate shock
• Inflation will more often surprise to the upside
• Disinflation drivers make better narrative stories than real economic sense

David Jane, manager of Miton’s multi-asset fund range, comments:

“2018 has continued where 2017 left off with strong rises in global equity markets, the UK excepted, and a healthy corporate bond market, at least in terms of new issues. The only cloud on the horizon appears to be the prospect of rising bond yields and interest rates as inflation creeps back into the system.

“Against this seemingly bullish background, it pays to consider what might go wrong. Among the more likely scenarios at present is that inflation rises much more rapidly than is currently considered likely. Following 30 years of disinflation, the greatest majority of observers seem to believe that inflation is beaten and if it returns at all it will be only temporary. It was this environment that led to the huge 30-year decline in government bond yields. Some commentators now suggest that this very long-term trend is coming to an end or has indeed already finished. We would broadly concur with that view, although such a long-term trend will not reverse instantly.

“The reasons given for the disinflationary period vary and tend to reflect the view point of the commentator as much as any real understanding. Economics is far from scientific. For a long time, the most popular theory was central bank prudence and independence. During the rise, monetarist economics inflation targeting became a popular central banking approach and many central banks were freed from government interference to focus on reducing the dreaded inflation.

“Obviously it’s natural for central bankers to presume they were successful for what they did, not for when they were working, so for many years the falling long term inflation rate was presumed to be because central bankers were now more sophisticated and successful in their policy implementation. This viewpoint is not consistent with the post financial crisis era, where interest rates have been low or even negative, a huge amount of money has been created and still inflation hasn’t returned to any meaningful degree. Therefore, other explanations have become popular more recently.

“A much more credible explanation is the rise of China. The introduction of a huge new workforce to the world economy in China clearly led to a massive reduction in wage pressures worldwide. Numerous data points exist which suggest that outside those highly specialised roles, who could sell their skills to a greatly expanded global marketplace, more mainstream workers struggled to achieve any growth in their earnings as they compete with a much larger global workforce. This condition no longer exists, China’s working age population is now expected to decline and there are no obvious huge untapped work forces about to join the world economy on the horizon.

“A related factor was globalisation, the rise of China coincided with a material reduction in the barriers to global trade, via China joining the WTO and a generally supportive political environment worldwide for free trade. Not often talked about was the reduction in technical barriers to trade such, as the introduction of containerised shipping, which led to a huge fall in the logistical costs of long distance trade.

“It’s quite clear that the political environment, at least in the West, is no longer as supportive of free trade, and the US is by far the biggest market for traded goods. China’s One Belt One Road strategy may lead to the opening up of trade in the Central Asian region through to Europe and reduce the cost of transport throughout the region, but this is unlikely to be as deflationary as the growth of US/China trade from 1980 onwards.

“Technology also plays a part.  Perhaps better communication (the rise of the smartphone and the internet) has led to greater price competition due to the reduction in barriers to price discovery. Or maybe consumers are spending more of their incomes on less resource intensive products, experiences rather than physical goods. Or maybe the products consumers now buy have vastly greater economies of scale (obviously an app can be downloaded at miniscule marginal cost) making increased demand less inflationary.

“These arguments all make much better narrative stories than they do real economic sense when you consider that the size of the economy is the sum of all its inputs. Broadly, improvements in productivity such as these lead to increased incomes to be spent elsewhere.

“It seems that none of the factors which gave rise to the broadly disinflationary era apply anymore, which doesn’t mean we are necessarily in an inflationary era but other things being equal the future is as likely to be one of rising inflation as falling inflation.

“In the near term, are we likely to see an upside surprise in the inflation data, leading to an interest rate shock? Quite possibly, labour markets are tight, the oversupply of natural resources seems to be much reduced and OPEC appears to be determined to not allow material falls in the oil price. To us, the balance is that inflation will more often surprise to the upside than the downside compared to the past. Therefore, our preference is for assets that have defensiveness against rising interest rates and benefit from inflation, compared to what has recently been regarded as defensive, such as beneficiaries of falling interest rates with strong pricing power.”