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.
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.
Aside from structural factors, inflation will also be constrained by normal economic and market dynamics. For example, the US Federal Reserve is limited in how far it can raise rates at a time of loose monetary policy globally. As rates rise to head off higher inflation, the US dollar is likely to strengthen, lowering the cost of US imports. This dynamic should be sufficient to limit the extent of the uplift to inflation from a tighter labour market or higher trade tariffs.
Furthermore, there are grounds for scepticism on how inflationary a Trump administration will be. While Mr Trump has promised to invest more in infrastructure, his only policy document on the subject focused on encouraging private investment, rather a government splurge. How far his proposals will get past Congress, where there are many Republican fiscal hawks, is also debatable. The headwinds to inflation in the UK are less benign – coming mainly as uncertainty from the referendum result feeds into lower investment and, by extension, a weaker labour market and lower demand.
When it comes to positioning a portfolio, investors therefore face an environment of steady growth, with inflation gradually rising. This is clearly negative for government bonds, and although they have retraced much of their 2016 gains, there is still room for further correction. Inflation linked bonds are an obvious choice to play higher inflation, but investors may also consider asset classes with less obvious inflation linkage – such as certain infrastructure or loan vehicles.
The outlook for equities in this more reflationary environment is less clear. While stock markets should do better going forward on the prospects of steady or even better growth in some places, significant political uncertainty is likely to continue driving the markets more than economic fundamentals.
The main risk events include the heavy political timetable in Europe, the process of the UK exiting the EU as well as Mr Trump’s policy path which remains highly uncertain. With markets likely to be volatile in the year ahead, ensuring that any equity portfolio is diversified regionally and counterweighted by some fixed income exposure is likely to be the best option.
Anna Stupnytska is a global economist at Fidelity International
Key points
More inflation is in the pipeline as base effects from commodity prices feeds through.
In the UK, a Bank of England estimate implies a 13 per cent to 18 per cent pass-through from sterling depreciation.
significant political uncertainty is likely to continue driving the markets more than economic fundamentals.
