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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. 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