Viewpoints

Inflation Awakening

The road ahead could look very different for inflation, and investors may want to consider whether they are prepared.

Is inflation coming out of hibernation? A significant breakout of higher inflation is not our base case inflation outlook over the secular (three- to five-year) horizon. However, as labor markets tighten and the global economy feels the ripple effects of growing populism across much of the developed world, higher inflation certainly looks like a bigger risk than it has been over the past decade.

The idea behind the potential rude awakenings highlighted in our latest Secular Outlook is that investors could be misled by their rearview mirrors – and inflation is one of the macro factors that could look substantially different on the road ahead. For the past 10 years, large output gaps in every part of the world ensured an ample supply of labor. This logically translated into lackluster wage growth and limited price pressures.

Now nearly a decade into the recovery, unemployment rates have not only returned to pre-crisis levels, but in some instances are reaching record lows. In the U.S., for example, you’d have to go back almost 20 years to find an unemployment rate below 4% – and our baseline forecast for 3.5% unemployment by the end of this year would be close to the record low of 3.4% in the late 1960s (which preceded one of the largest and longest inflation episodes of the post-war era). In the U.K., unemployment is back to a level last seen in the early 70s. And while southern Europe is still lagging and has plenty of spare capacity, Germany’s unemployment rate is at a multidecade low.

What happened to the Phillips curve?

Yet despite the tight labor market, wages have remained stagnant. This has raised questions about the robustness of the so-called Phillips curve – a cornerstone of most central banks’ frameworks which postulates that as an economy gets close to full employment, wages and inflation should accelerate. Confronted with a long period of subdued inflation, central bankers are de-emphasizing the predictive power of the Phillips curve and have remained extremely cautious in removing their extraordinary monetary policy accommodation.

But what if the Phillips curve is alive and well, and hidden slack is the reason for depressed wage growth? If this is the case, central bankers could already be behind the curve and may be keeping rates too low for too long. And even if this is not the case, a growing number of central bankers appear comfortable with letting inflation run above their targets in order to re-anchor inflation expectations at a higher level. The Federal Reserve itself is forecasting inflation above 2% in 2019 (as measured by personal consumption expenditure, or PCE, inflation), yet reaffirmed its view that interest rates should be normalized at a slow and gradual pace. The dovish bias of central banks is still solidly anchored.

Fiscal expansion and populism may stoke the fire

Add to tightening labor markets two potentially significant drivers of economic change that we identified in our Secular Forum: fiscal profligacy and rising populism. More and more countries have elected populist governments that are introducing serious doses of fiscal expansion through tax cuts and potentially increased spending – all at a time when one would expect deficits to contract. In the U.S., for instance, the budget deficit is growing despite very low unemployment and limited spare capacity in the economy, leading one to logically wonder how real output will be able to meet the increase in aggregate demand (see Figure 1). And higher demand coupled with constrained supply is a textbook recipe for higher inflation.

Inflation Awakening – Inflation Outlook Midyear 2018 

The impact of populism doesn’t stop at higher public deficits. Both the populist left and the populist right appear unified in their hostility toward globalization and trade. U.S.-imposed tariffs have been limited so far, and we believe even the proposed 10% tariff on $200 billion of additional Chinese goods would have a measured impact on inflation; by our estimates, it would raise core inflation by just 0.1% to 0.15% over the next 12 months. The proposed tariffs on cars imported from Europe and Japan pose a larger threat, in our view, potentially boosting inflation by as much as 0.5%.

What about the tariffs’ longer-term impact? Much would depend on whether the U.S. can repatriate production from low-wage countries – a dubious prospect, in our view, given near-full employment and the administration’s restrictions on immigration. To gauge the potential impact over the next five years, we ran simulations based on the Federal Reserve’s FRB/US macroeconomic models, using different trade elasticities addressing the ability of the U.S. economy to replace imports with domestic production. We found inflation to be higher in all scenarios, with some persistence effect.

Last but not least, oil prices continue to climb as OPEC struggles to increase output amid production outages around the world (from Libya to Canada and Venezuela) and the sanctions on Iran.

Old patterns may not hold in a less-benign inflation outcome

While most markets and economists still have a benign view of inflation, we see a material possibility of higher inflation that could have profound implications, not just on real returns across assets, but also on market volatility and portfolio construction. Many investors have grown accustomed to the reliably negative correlation between stocks and bonds as they seek to diversify and dampen volatility from portfolios of risky assets. However, as we have pointed out before, this correlation has generally only been reliable when inflation is low or falling (see Figure 2).

Inflation Awakening – Inflation Outlook Midyear 2018 

To be sure, we believe high quality bonds will most likely provide an effective portfolio hedge against the downside potential in risk assets in the case of a recession, and we see a recession as likely  over the secular horizon; however, as the stock market correction earlier this year demonstrated, this approach might not work as well if inflation fears are driving the risk-off moves. The correction in early February began with a much higher-than-expected Consumer Price Index (CPI) print in January, followed by above-consensus wage data in the first week of February. At the same time, Treasury yields surged. If high quality bonds could not hedge your portfolio, so the logic seemed to go, then the only option was to sell your risky assets – a conclusion that resulted in increased market volatility and drawdowns in risk assets.

Yet the market assigns a low probability to persistently high inflation, as seen in the term structure of market-based measures of inflation compensation, such as breakeven inflation (BEI). When comparing yields on nominal Treasuries to those for Treasury Inflation-Protected Securities (TIPS), for example, five-year BEI is now higher, at 2.21%, than 30-year BEI, at 2.12%. This implies an expectation that inflation pressure will rise in the near term, perhaps due to the impact of higher commodity prices, near-full economic capacity or tariffs, but that inflation risk will be much lower in the longer term.

Investor takeaways: Preparing for an inflation awakening

Although our baseline inflation outlook does not envision a rapid acceleration over the secular horizon, we see greater inflation risk than in recent years – and we believe many investors may be underestimating the possibility of a longer-term inflation surprise. Such longer-term risk could be very disruptive; as Figure 2 shows, it would imply a change in correlation between major assets by depressing prices for bonds and equities at the same time. This could be another rude awakening for investors who may have assumed their portfolios were balanced.

While we believe investor portfolios in general properly account for growth risks, we think investors should consider whether they are adequately protected against rising inflation. Considering a standalone or combined allocation to real assets – such as inflation-linked bonds, commodities, real estate investment trusts (REITs) or other inflation-fighting assets – is one way investors may seek to hedge their portfolios and potentially enhance returns in the event that an inflationary regime emerges.

For more of PIMCO’s views on the complex drivers of inflation, please visit our inflation page.

The Author

Jeremie Banet

Portfolio Manager, Real Return

Mihir P. Worah

CIO Asset Allocation and Real Return

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