EconomyMar 29 2018

Will Trump spark the wrong or right type of inflation?

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Will Trump spark the wrong or right type of inflation?

This was the notion that the president’s populist political style would lead to more government spending and tax cuts – policies typically inflationary in nature. With Mr Trump’s economic stimulus taking place amid an already expanding economy, this in turn would prompt the Federal Reserve to raise interest rates at a faster pace than it might otherwise have.

It was these expectations that combined to form the Trump trade, with US bonds selling off towards the end of 2016 and the shares of firms such as banks prospering. Banks perform well when economic growth is strong and bond yields are rising, as higher rates allow them to boost their margins.

After a pause in early 2017, the trade took off again at the end of the year. But not all investors drew a positive inference from Mr Trump’s actions. Peter Elston, chief investment officer at Seneca, has sold all of his US equity exposure over the past year.

Business cycles

Mr Elston subscribes to the economic theory of business cycles, as advocated by the Austrian school of economics, which states that economies move from recession to expansion, and then to recovery. The expansion stage is marked by strong economic growth and low interest rates that start to gradually move upwards.

The final stage sees rates ultimately rise at a faster pace than the economy can handle, with the result that they begin to erode economic growth and eventually eradicate it, leading to recession.

By taking actions intended to stimulate further economic activity, such as the recent move to cut the main rate of corporation tax from 35 per cent to 21 per cent, the president may be speeding up these cycles. The theory is that an economy previously in the expansion phase accelerates into the recovery phase – characterised by inflation rising at a faster pace – and the resultant interest rate rises tip the country into a shallow recession.

If rates are not increased, stimulus risks creating an excess of borrowing or even a credit bubble. The bursting of such a bubble is likely to be a far worse outcome for the economy in question than a moderate rise in rates leading to a mild recession, according to Andy Haldane, chief economist at the Bank of England, speaking to the Treasury select committee in February.

Trevor Greetham, head of multi-asset investing at Royal London Asset Management, says the introduction of tax cuts by president Trump prompted the increased volatility seen in markets in February, because investors felt the stimulus would shunt the US economy into the later stages of the cycle.

Keynesian economic theory encourages governments to pursue countercyclical economic policies. If the private sector part of the economy is expanding, the public sector should contract, and vice versa, as a way of preventing the sharp cyclical swings feared by Mr Elston.

Inflation outlook

Those who have sought to generate returns via Trump trade and those who are negative on the US economy are both basing their views on the idea that inflation will rise. 

However, a notable feature of the economic performance of the US, and much of the rest of the world in 2017, was a lack of inflationary pressure. This perpetuated a ‘goldilocks’ scenario, where economic growth was still in train but inflation was low, so there was little motivation for the Fed to hike interest rates.

To use Mr Elston’s example, it meant the US economy was not moving from an expansionary to a recovery phase. As a result, the next recession was being pushed further into the future.

It was Mr Trump’s introduction of the tax cuts that caused the wider market to believe the cycle was moving to a later stage. Advocates say the policy will encourage businesses to create jobs, or raise salaries for existing workers. But the latest inflation data from the US, covering February, showed core inflation at 1.8 per cent, unchanged from a year ago. That data followed an update on wage growth that showed little sign of an upward move in salaries. This trend, which comes despite US unemployment sitting at a 17-year low, increases the likelihood of inflation remaining subdued.

Many fund managers retain their faith in the Phillips curve – the economic concept that states higher employment levels in an economy lead to higher inflation and, later, to higher interest rates.

Richard Buxton, fund manager and chief executive of Old Mutual Global Investors, says the principles of the curve are a “law of nature” and so will be vindicated in time. He has positioned his £2.3bn Old Mutual UK Alpha fund for just this scenario, with significant investments in banks and mining companies.

Jacob de Tusch-Lec, who runs the £4bn Artemis Global Income fund, says market volatility is the result of investors realising that inflation will soon move higher, and consequently moving into banks and other investments and out of bonds and the equities that perform most like bonds, notably consumer staples.

Bond fund managers, for whom inflation would be a less welcome sight, disagree. Stephen Snowden, manager of the Kames Investment Grade Bond fund, says the lack of inflationary pressure is partly the result of the poor quality nature of the jobs being created. 

His analysis is that wages will not rise markedly, neither will inflation or interest rates, and bond yields will remain low. This means the shares that have performed well during the Trump trade, such as banks and mining companies, will start to struggle again. 

Mr Snowden thinks the world economy is mutating into a clone of the Japanese economy, with permanently low growth and low inflation.

Protectionism

While market participants debate the reliability of the Phillips curve and the potential for bond yields to rise further, all corners are in agreement that the US president’s newly proposed protectionist policy of levying tariffs on imported steel will be negative for the country’s economy and market. This is partly because there are more people employed in the US in industries that consume steel than there are in steel manufacturing.

Tariffs mean steel prices will rise, pushing up costs for companies that use the alloy to manufacture other products. Some of those businesses may not be able to survive the higher prices, and will lay off workers, pushing unemployment up and economic growth downwards. Higher steel prices could also be inflationary, as the cost of manufacturing rises and firms pass on the higher prices to their customers.

But this is not the inflation that Mr de Tusch-Lec and others are expecting. They expect faster economic growth to increase the demand for goods and services at a pace faster than the supply of goods rises. In the short term, this is good for economic growth as it entices firms to expand in order to sell into a market where demand is rising, creating more jobs and higher wages. Economists call this demand-pull inflation.

Inflation caused by an increase in the cost of production, such as steel prices rising, is generally bad for economic growth because higher production costs drive firms out of business, pushing unemployment up. This is commonly known as cost-push inflation, which leads to higher prices as economic growth slows, and is known as ‘stagflation’. This type of inflation is currently the biggest threat to the US economy, says Neil Williams, senior economic adviser at Hermes. 

Andrew Bell, chief executive of Witan, says higher oil prices are already injecting this “wrong sort” of inflation into the US economy, compressing its growth potential since oil is also an input cost. He said the risk of US interest rate hikes as a result of this cost-push inflation is the biggest threat to global investment markets. 

Consequently, the jury is still very much out on the question of which type of inflation – if any – will make a comeback in the coming months.

David Thorpe is investment reporter at FTAdviser.com. Russell Taylor is away