Download PDF - Lazard Asset Management

Lazard Insights
From Deflation Fears
to Inflation Concerns
Ronald Temple, CFA, Co-Head of Multi-Asset and Head of US Equity
Summary
• Over the past couple of years, persistently
low inflation has concerned policymakers and
investors. More recently, however, expectations
have reached an inflection point and rising inflation
has emerged as a key investment risk.
• Inflation should rise as the economy nears its full
potential and the labor market continues to tighten.
In 2015 and 2016, these cyclical pressures were
partially obscured by falling energy and import
prices, transitory factors which have now faded.
• Several structural factors have contributed to
a global convergence in inflation and interest
rates over the past three decades. If this trend is
reversing, there could be a substantial risk of higher
inflation in the years ahead.
• Different investments respond to inflation in
different ways. We believe investors should aim
for a flexibile approach that may change allocations
depending on how inflation manifests itself, while
also generating income and capital appreciation.
Lazard Insights is an ongoing series designed to share valueadded insights from Lazard’s thought leaders around the
world and is not specific to any Lazard product or service.
This paper is published in conjunction with a presentation
featuring the author. The original recording can be accessed
via www.LazardNet.com/insights.
In recent years, persistently low inflation became a genuine
concern for policymakers and investors. A variety of theories have
emerged as to why, eight years into the recovery, there is not more
inflationary pressure. However, expectations have reached an
inflection point and rising inflation has become a key investment
risk. Our base case expectation is that inflationary pressure will
continue to grind higher over the next two-to-three years and
that an economy running close to potential will lead to continued
tightening of the labor market and rising price pressures in housing
and health care. In this base case scenario, inflation is likely to be
between 2%–3%. In our bear case scenario, the global forces that
produced the relatively moderate and stable inflation of the past
30 years partially reverse. In this scenario, populist politics lead to
more protectionism, which would result in substantially higher
and less predictable inflation, at levels exceeding 3%.
In this paper, we evaluate how inflation evolved over the past few
decades, where we stand today, and what the consequences have
been for market expectations of future inflation. We also review
the different pressures rising inflation can place on an investment
portfolio and how to approach defending capital against those
pressures. Finally, we review some key assumptions investors
should question in addressing inflation risk.
2
Inflation in Context
As shown in the right chart in Exhibit 2, government bond yields
have followed a similar pattern over the past 30 years. In 1999, the
range between developed markets’ 10-year government bond yields
was near zero as investors mistakenly assumed the interest rate and
credit risks for these countries were the same. That misperception
was remedied in 2012 during the euro zone debt crisis, and the
range remains wider today than in the early 2000s but much
narrower than in the 1980s–1990s.
Over the past three decades, there has been global convergence in a
number of policy arenas, which may be coming to an end with the
recent rise in populist and protectionist politics. This convergence
encompassed increasing liberalization of trade and capital flows
and increasing consensus on how monetary policy should be
pursued. As a result, global inflation and interest rates converged
and markets became more correlated. The central question now is
whether this global convergence has merely stalled or is reversing.
If it is reversing, there could be a substantial risk of higher inflation
in the years ahead.
This broader context has contributed to relatively moderate and
stable inflation in the United States since the 1990s. The last
time the United States experienced sustained inflation in core
consumer prices in excess of 3% was in 1995, as measured by
either the CPI or the Personal Consumption Expenditure (PCE)
Price Index (Exhibit 3). One reason US inflation has been so low
is that is that the price of goods excluding energy and food has
risen at an average annual rate of just 0.05%—or less than 1%
cumulatively—since the turn of the century. During this same
period, the price of services excluding energy services has risen
at an average annual rate of 2.8%—or nearly 60% cumulatively.
While a number of factors may contribute to these diverging
trends, one undoubtedly has been the expansion of global trade
and global supply chains. Many services, like housing or health
care, are less exposed to these forces than most goods.
Monetary policy is one facet of this global convergence. Thirty
years ago, most central banks were far less independent than they
are today and none of them had explicit inflation targets. The first
central bank to introduce an inflation target was the Reserve Bank
of New Zealand in 1989. Ultimately, central banks across the
developed world followed, generally adopting inflation targets of
2% or in ranges close to 2% (Exhibit 1). Many emerging market
central banks have adopted the same approach, but with higher
targets in a number of cases. For example, the fact that Ghana has
an inflation target demonstrates that this has truly become a global
standard.
Over this same period of time, inflation and interest rates have
converged across developed economies. The left chart in Exhibit 2
shows that the year-on-year change in core Consumer Price Index
(CPI) in developed economies has both declined and narrowed in
dispersion since 1985. For example, in 1985, core inflation ranged
from around 3% in the Netherlands (second lowest) to over 13%
in New Zealand (second highest). In 2017, this range is now
0.2% to 2.0%.
Recent Trends in US Inflation
Turning to recent trends in US inflation, we believe that cyclical
pressures have gradually built but were partially obscured by falling
energy and import prices over the past couple of years, transitory
factors which have now faded. During this period, the year-on-year
change in core CPI, which excludes food and energy prices, has
been relatively stable but has slowly risen from about 1.7% at the
beginning of 2015 to 2.2% in early 2017.
Exhibit 1
Central Banks Began Introducing Inflation Targets in 1989
Current Inflation Target (%)
8
Developed Market
6
Emerging Market
4
2
New
Zealand
Ghana
South
Brazil Africa
Chile, Colombia
Poland
Australia
1989
1991
1993
1995
1997
1999
2001
2003
Turkey
Armenia
Serbia
Romania
Israel
Peru
Thailand
Korea,
Czech
Republic Euro Zone Norway, Iceland
Canada UKSweden
0
Guatemala, Indonesia
Mexico Philippines
2005
2007
2009
2011
US Japan
2013
2015
Date of Introduction
As of 2015
Dates correspond to formal adoption. Chart adds the US and Japan to countries listed in the BOE report. Inflation targets are current targets. Marker indicates the midpoint of inflation
target ranges.
Source: Bank of England, central bank websites, “State of the Art of Inflation Targeting – 2012”
3
Exhibit 2
Inflation and Interest Rates Have Converged Over the Last 30 Years
Core CPI in 20 Developed Economies
10-Year Government Bond Yields in 20 Developed Economies
Y/Y Change (%)
(%)
18
18
2nd−19th Range
Median
12
12
6
6
0
0
-6
1985
1989
1993
1997
2001
2005
2009
2013
2017
2nd−19th Range
Median
-6
1985
1989
1993
1997
2001
2005
2009
2013
2017
Core CPI as of January 2017. 10-year government bond yields as of February 2017
Sample includes: Australia, Austria, Belgium, Canada, Denmark, Finland, France, Germany, Ireland, Italy, Japan, Netherlands, New Zealand, Norway, Portugal, Spain, Sweden, Switzerland,
United Kingdom, United States. Australia and New Zealand CPI are disaggregated quarterly data series.
Source: Haver Analytics, national sources
prices. This “pass through” effect likely exerted downward pressure.
Similarly, a decline in import prices also helped depress inflation. US
dollar strength, particularly in 2015, led to non-petroelum import
price declines of as much as 3.7% in 2015, lowering the overall
inflation rate. However, as the rapid appreciation of the dollar has
subsided, import prices have begun to rise again.
Exhibit 3
US Core Inflation Last Topped 3% in 1995
Y/Y Change (%)
15
12
9
6
3
0
1966
Core CPI
1979
Core PCE
1991
2004
2017
As of January 2017
Source: Bureau of Labor Statistics, Haver Analytics
However, energy has likely been a drag. The effects of the decline
in oil prices from late 2014 through early 2016 can be seen in the
difference between headline CPI inflation, which includes energy
prices and has swung sharply, and core CPI inflation. The year-onyear change in headline CPI fell to roughly 0% in 2015, opening a
gap with core CPI inflation that approached two percentage points.
The recovery in oil prices since early 2016 has now lifted headline
CPI inflation above core CPI inflation, adding half a percentage
point to February’s year-on-year change in headline CPI.
While core CPI excludes the direct contribution of food and energy
prices, it still captures their indirect contribution as an input to other
Trends in wage growth have been consistent with this view of
underlying inflationary pressure. We monitor wages closely,
both because they reflect the economic cycle and because unit
labor costs, or compensation per output, are an important cost
to businesses. In 2013, year-on-year wage growth on average
bottomed at around 1.5% as measured by a simple average of
three common wage measures. This average has since gradually
accelerated, reaching 2.7% at the end of 2016. We expect wages to
grind higher through 2017 and into 2018 as the US labor market
continues to tighten.
Importantly, the wage recovery has begun to broaden in the
last two years (Exhibit 4). The top end of the wage scale has
experienced the strongest gains since the turn of the century,
with cumulative real wage increases of 19.8% for workers in the
top 5% of the distribution and 15.7% for those in the top 10%.
Notably, the workers in the 70th, 50th, 30th, and 10th percentiles
of income did not really participate in the wage gains from 2000 to
2016. However, the most recent data for 2016 shows a meaningful
increase in income levels for all of these categories except the 70th
percentile. We believe this is an important development because
rising income for more households should support and extend the
ongoing economic recovery. This too could contribute to stronger
cyclical inflationary pressure.
4
Exhibit 4
Wage Growth Recovery Has Begun to Broaden Recently
Exhibit 5
The Relationship between Wages and Unemployment Has
Changed Over Time
Cumulative Change in Real Hourly Wages by Wage Percentile,
2000–2016
(%)
20
19.8% 95th Y/Y Change in Average Hourly Earnings (%)
4.5
R² = 0.52
4.0
15
15.7% 90th
3.5
Percentile
R² = 0.81
3.0
10
2.5
5.3%
5.0%
4.8%
2.2%
5
0
-5
2000
2004
2008
2012
70th 10th 50th 30th 2016
As of 2016
Sample based on all workers age 18–64. The xth-percentile wage is the wage at
which x% of wage earners earn less and (100 - x)% earn more. EPI analysis of Current
Population Survey Outgoing Rotation Group microdata.
Source: Economic Policy Institute, “The State of American Wages”
A notable aspect of this recovery has been that inflation and wages
did not decline as dramatically as one might expect following
the crisis and have not risen as one might expect at this stage of
the expansion. There was a somewhat predictable relationship
between wages and unemployment from the pre-crisis years
of 1996 to 2007, which can be characterized as a period with
relatively moderate and stable inflation (Exhibit 5). Periods of
low unemployment coincided with relatively high wage growth
and vice versa. However, from 2007 to 2011, or the peak of
the pre-crisis housing bubble through the first three years of the
recovery, wage growth remained higher than expected given the
significant increase in unemployment. Furthermore, while wage
growth has accelerated since 2011 as unemployment declined, it
has done so much more gradually than in the pre-crisis years.
One explanation for the flatter relationship between wages and
unemployment since the crisis could be that companies cut
headcount rather than wages during the downturn. As a result,
wage growth for those with jobs remained higher than expected
while unemployment rose sharply. Perhaps what we have seen in
recent years is that companies are adding headcount rather than
increasing wages. If this is the case, we could see pent-up upside
in wages as we have returned to low levels of unemployment and
employers need to pay more to hire quality workers.
In evaluating recent trends in inflation, it is also important to
consider how rapidly prices are changing for different components
of the basket of goods and services that make up inflation indices.
The costs of housing and health care services are two particularly
important components. They tend to experience more rapid cost
increases than the overall index and they together account for
2.0
1.5
1.0
3.5
1996−2007
4.5
2007−2011
5.5
6.5
2011+
7.5
R² = 0.37
8.5
9.5
10.5
Unemployment Rate (%)
As of February 2017
Average hourly earnings is for production and nonsupervisory workers in all private
industries.
Source: Bureau of Labor Statistics, Haver Analytics
approximately 45% of both the CPI and the PCE Price Index,
although in different proportions (CPI weights housing more
heavily). Exhibit 6 displays these components as measured by CPI.
Housing-related inflation has accelerated dramatically from very
low levels following the crisis and is now above the average level
observed in the five years before the crisis. Health care inflation
has also increased from the lows seen in 2014 and 2015, but it
remains well below its pre-crisis average. Keep in mind that the CPI
measures out-of-pocket expenses rather than total spending. As
such, any changes in government health care policy that increases
the proportion of health care costs that are borne by the consumer
or otherwise contributes to a re-acceleration in health care prices will
increase CPI inflation readings.
Investment Implications
So, what does all of this mean for investors? We believe we have
reached an inflection point as it relates to inflation. Deflation
risks have effectively disappeared and have been replaced by rising
inflation expectations, which have rebounded from the lows
observed in February 2016. We believe that based on cyclical factors
alone, inflation of 2.0%–2.5% is a probable scenario. However, in
our bear case scenario in which there is a sustained backlash against
globalization, populism could lead to protectionism, which leads to
higher prices. In this bear case scenario, inflation could rise to 3% or
higher depending on the course of events.
This is not a cause for alarm, but it is a reason for investors to
re-evaluate their asset allocation decisions to ensure portfolios defend
against rising inflation. Thirty years ago, investors might have chosen
to buy gold or large cap equities if they were worried about inflation.
5
Exhibit 6
Health Care and Housing Services Drive Inflation
Housing Inflation Is Above Pre-Crisis Average
Health Care Inflation Has Lagged
Y/Y Change (%)
5
Y/Y Change (%)
7
6
4
4
2
3
CPI Shelter
1
2
0
-1
2004
2002–2007 Average
5
2002–2007 Average
3
CPI Medical Care Services
1
2006
2008
2010
2012
2014
2016
0
2004
2006
2008
2010
2012
2014
2016
As of February 2017
Housing accounted for 38.9% of the CPI-U All Items basket and approximately 21.5% of nominal PCE as of December 2016. Health care services accounted for 8.5% of the CPI-U All
Items basket and approximately 22.9% of nominal PCE as of December 2016.
Source: Bureau of Labor Statistics, Federal Reserve Board, Haver Analytics
Today, investors have more choices when it comes to inflation
protection and it is important to recognize that different investments
respond to inflation in different ways. Liquid real assets are an
excellent option for investors, in our view, as they allow flexibility
to change allocations, depending on how inflation manifests itself,
while also generating income and capital appreciation. Consider
three scenarios.
In the first scenario, current trends accelerate: the long recovery from
the financial crisis continues, slack diminishes further, and cyclical
pressures build. In such a scenario, wage growth should be expected
to continue to grind higher, as discussed earlier. If productivity
growth remains low, growth in unit labor costs would accelerate,
raising the cost of doing business, especially for labor-intensive
companies. In this instance, an investor may want to consider
allocating capital to companies that have empirically demonstrated
the ability to pass through rising input costs to their customers.
We say these companies have “pricing power.” Similarly, cyclical
pressures could cause home prices and rents to accelerate further. In
this instance, real estate investments would likely benefit.
The second scenario envisions upward pressure on inflation
through international channels. Protectionist measures could
be inflationary, raising the cost of imported goods and services
and reducing competition for domestically produced goods and
services. In such a scenario, companies with pricing power might
again be best positioned to pass on rising input costs and protect
their profit margins. Alternatively, just as an appreciating US dollar
was a source of downward pressure on inflation, a depreciating
dollar would be a source of upward pressure on inflation. In such a
scenario, commodities priced in US dollars might benefit, as they
would become cheaper in other currencies.
The third scenario envisions additional cyclical pressures resulting
from policy change. A combination of new fiscal stimulus from either
tax cuts or new infrastructure spending and a US Federal Reserve
that did not react by more rapidly tightening monetary policy should
place upward pressure on inflation. In both instances, income from
inflation-linked bonds would be protected in real terms. If the
stimulus were to come from new infrastructure spending, related
sectors should benefit, including infrastructure and commodities.
Conclusion: Questioning Assumptions
about Inflation
In closing, we think investors need to question some assumptions
about inflation. For example, the idea that inflation and interest
rates will be lower for longer seems unlikely at this point. Higher
risk of inflation and higher interest rates have implications
for volatility and risk premia and could be a negative for fixed
income and equities that have served as bond proxies. Another
misconception is that inflation is always the same. It is critical to
recognize that inflation can increase for a range of reasons and that
inflation in the next few years is unlikely to look like inflation in
the 1970s. Inflation over the last eight years has not behaved as
economic theory or many forecasters had predicted.
Another flawed assumption is that all inflation hedges are created
equal. There are clear differences in how different assets and
asset classes behave in different circumstances. Depending on
what drives inflation, it is important to be nimble in terms of
investments. Finally, illiquid investments are presumed by many
to be a better inflation hedge than liquid assets. We disagree. It
is important to be able to adjust to how inflation manifests itself
and to be nimble in protecting capital. Illiquid assets can play a
role, but we would suggest that liquid real assets could be a better
approach or at minimum should be part of the solution.
6
This content represents the views of the author(s), and its conclusions may vary from those held elsewhere within Lazard Asset Management.
Lazard is committed to giving our investment professionals the autonomy to develop their own investment views, which are informed by a
robust exchange of ideas throughout the firm.
Important Information
Published on 2 June 2017.
Information and opinions presented have been obtained or derived from sources believed by Lazard to be reliable. Lazard makes no representation as to their accuracy or completeness. All
opinions expressed herein are as of 30 March 2017 and are subject to change.
Equity securities will fluctuate in price; the value of your investment will thus fluctuate, and this may result in a loss. Securities in certain non-domestic countries may be less liquid, more volatile,
and less subject to governmental supervision than in one’s home market. The values of these securities may be affected by changes in currency rates, application of a country’s specific tax laws,
changes in government administration, and economic and monetary policy. Emerging markets securities carry special risks, such as less developed or less efficient trading markets, a lack of
company information, and differing auditing and legal standards. The securities markets of emerging markets countries can be extremely volatile; performance can also be influenced by political,
social, and economic factors affecting companies in these countries. Small- and mid-capitalization stocks may be subject to higher degrees of risk, their earnings may be less predictable, their
prices more volatile, and their liquidity less than that of large-capitalization or more established companies’ securities.
This material is provided by Lazard Asset Management LLC or its affiliates (“Lazard”). There is no guarantee that any projection, forecast, or opinion in this material will be realized. Past performance does not guarantee future results. This document is for informational purposes only and does not constitute an investment agreement or investment advice. References to specific
strategies or securities are provided solely in the context of this document and are not to be considered recommendations by Lazard. Investments in securities and derivatives involve risk,
will fluctuate in price, and may result in losses. Certain securities and derivatives in Lazard’s investment strategies, and alternative strategies in particular, can include high degrees of risk and
volatility, when compared to other securities or strategies. Similarly, certain securities in Lazard’s investment portfolios may trade in less liquid or efficient markets, which can affect investment performance.
Australia: FOR WHOLESALE INVESTORS ONLY. Issued by Lazard Asset Management Pacific Co., ABN 13 064 523 619, AFS License 238432, Level 39 Gateway, 1 Macquarie Place, Sydney
NSW 2000. Dubai: Issued and approved by Lazard Gulf Limited, Gate Village 1, Level 2, Dubai International Financial Centre, PO Box 506644, Dubai, United Arab Emirates. Registered in Dubai
International Financial Centre 0467. Authorised and regulated by the Dubai Financial Services Authority to deal with Professional Clients only. Germany: Issued by Lazard Asset Management
(Deutschland) GmbH, Neue Mainzer Strasse 75, D-60311 Frankfurt am Main. Hong Kong: Issued by Lazard Asset Management (Hong Kong) Limited (AQZ743), Unit 7, Level 20, One
International Finance Centre, 1 Harbour View Street, Central, Hong Kong. Lazard Asset Management (Hong Kong) Limited is a corporation licensed by the Hong Kong Securities and Futures
Commission to conduct Type 1 (dealing in securities) and Type 4 (advising on securities) regulated activities. This document is only for “professional investors” as defined under the Hong Kong
Securities and Futures Ordinance (Cap. 571 of the Laws of Hong Kong) and its subsidiary legislation and may not be distributed or otherwise made available to any other person. Japan: Issued by
Lazard Japan Asset Management K.K., ATT Annex 7th Floor, 2-11-7 Akasaka, Minato-ku, Tokyo 107-0052. Korea: Issued by Lazard Korea Asset Management Co. Ltd., 10F Seoul Finance Center,
136 Sejong-daero, Jung-gu, Seoul, 04520. People’s Republic of China: Issued by Lazard Asset Management. Lazard Asset Management does not carry out business in the P.R.C. and is not a
licensed investment adviser with the China Securities Regulatory Commission or the China Banking Regulatory Commission. This document is for reference only and for intended recipients only.
The information in this document does not constitute any specific investment advice on China capital markets or an offer of securities or investment, tax, legal, or other advice or recommendation or, an offer to sell or an invitation to apply for any product or service of Lazard Asset Management. Singapore: Issued by Lazard Asset Management (Singapore) Pte. Ltd., 1 Raffles Place,
#15-02 One Raffles Place Tower 1, Singapore 048616. Company Registration Number 201135005W. This document is for “institutional investors” or “accredited investors” as defined under
the Securities and Futures Act, Chapter 289 of Singapore and may not be distributed to any other person. United Kingdom: FOR PROFESSIONAL INVESTORS ONLY. Issued by Lazard Asset
Management Ltd., 50 Stratton Street, London W1J 8LL. Registered in England Number 525667. Authorised and regulated by the Financial Conduct Authority (FCA). United States: Issued by
Lazard Asset Management LLC, 30 Rockefeller Plaza, New York, NY 10112.
RD00199