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Readying portfolios for inflation

Readying portfolios for inflation

Despite the dominance of the ‘lower for longer’ narrative since the crisis – and certainly for much of 2016 – the fourth quarter has seen markets scrambling to price in higher inflation. With the exception of Japan, we have seen a broad pick-up in developed market headline inflation over the year, mainly driven by a rebound in commodity prices.  More inflation is in the pipeline as base effects from commodity prices continue to feed in.

While oil has fallen back from its 2016 highs – having doubled at one point – it is likely to feed through particularly strongly in the first quarter of 2017. 

Excluding food and energy, inflationary pressures have been more subdued as core inflation has stayed broadly stable through the year. But more momentum in core measures should become visible as we move into 2017.

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There are clear signs of accelerating wage growth, particularly in the US (chart below), indicating the labour market must be very close to its equilibrium level of unemployment (an unobservable variable which might have changed since the crisis, adding to the Fed’s challenges).

Although the recovery from the financial crisis has been gradual, higher wages should feed into higher inflation, something markets had been complacent about. Acceleration in US wage growth could feed into higher inflation.

In addition to supportive labour market trends, there are also idiosyncratic factors which might lead to US/UK inflation rising more strongly than elsewhere. The UK’s decision to leave the European Union has led to a sharp depreciation in sterling, with a 2015 Bank of England’s estimate implying a 13 per cent to 18 per cent pass-through from sterling depreciation. In its November Inflation Report, the Bank expected an inflation rate of 2.8 per cent in the fourth quarter of 2017, higher than its August forecast immediately following the EU referendum.

In the US, the return of inflation has been given a boost by the surprise victory of Donald Trump. The potential for fiscal stimulus in the form of tax cuts and infrastructure spending would add to inflation momentum, though the extent of this depends on the scale of any package.

Trade protectionism too, if implemented, could result in higher US inflation, with some estimating a one-off boost to US inflation of between 30 to 50 basis points. While many in markets will be hoping that Mr Trump’s policy platform becomes more moderate, it is notable that he has not shifted from his campaign rhetoric on trade as much as he has on issues such as the Mexican border wall (where a fence is now acceptable). 

However, with markets having shifted from the ‘lower for longer’ rhetoric to significant inflation worries overnight, there is a danger that the upside potential to inflation will be overestimated. Mr Trump’s election has not reversed the secular global forces underlying disinflationary trends over the last decade, including globalisation, better information technology, ageing populations and the rise of China.

While we may see a degree of backlash against globalisation, it would be a long time before this had any structural impact on the economy. In the meantime, China will continue exporting deflation to the rest of the world as the renminbi continues on its depreciation trend.  With these forces still in place, global inflation is not running away.