We have already seen a shift from an outlook plagued by low inflation and nominal growth to higher expectations for both. In 2017, we expect concerns around potential secular stagnation to give way to a more inflationary paradigm in the US.
With tightening labor markets, a boost from energy price-related base effects and a potentially more inflationary fiscal outlook, prices and inflation expectations have already risen markedly from lows. We highlight the investment implications of this across rates and equities. We also highlight a risk; modestly higher inflation driven by an improving global growth outlook should be beneficial for assets, but unanchored expectations or a central bank response that is too aggressive could cause upsets.
How Much Inflation is Too Much?
The US Core Consumer Price Index (CPI) has been above 2% throughout 2016. Headline CPI has risen from a low of 0.8% this year to 1.6% (as of October 2016). And the tightness in US labor markets is manifesting in higher wages. Outside of US employment data, European manufacturing capacity utilization is also higher than any time since 2008 and most broadly of all, the IMF estimates the aggregate G7 output gap next year to be half what it was in 2015. We expect all of this to continue to drive prices higher.
Oil has been one of the standout contributors to lower inflation. We believe that, barring a further fall in the oil price, it now stands to be a key driver of higher inflation, purely through the mechanics of the year-on-year measurement of the CPI. These so-called base effects could be substantial, especially in the early part of 2017. We will be monitoring them closely.
We see the return of inflation as a positive development, as it represents a shift away from fears of secular stagnation to a healthier nominal growth environment. Higher employment and wage growth, more stable commodity prices, potential corporate profit growth and moderately higher rates will all have beneficiaries. However, inflation could be a double-edged sword in 2017 if too much gets priced in too quickly.
With US unemployment at 4.6% (as of November 2016), labor markets are tight and firms are struggling to fill positions. Inflation has been held down by its most volatile components (notably, energy prices). More stable components such as the cost of rent, insurance and utilities have been gradually rising. As a result, the risk of a sharp rise in the perception of price movements is elevated. Existing inflationary pressures, coupled with the expectation of some fiscal expansion globally—and potentially significant expansion in the US—have aligned to drive up market expectations of inflation. Bond markets are reflecting this risk; the 5-year, 5-years forward, rate of inflation has risen markedly. As a result, we will be watching market-based measures of inflation as closely as CPI prints themselves in 2017.
We believe the market’s perception of inflation will have the greatest impact on asset prices. In the event of expectations becoming unanchored, assets than can benefit may be hard to come by; bonds and equities will likely suffer and commodities will probably offer a limited cushion. US inflation-linked bonds (“TIPS”) may benefit, but after a substantial rally in 2016 we think TIPS are fairly valued relative to corporate credit and equities.
Oil Prices May Be Reflationary Even if They Stand Still from Here
Source: Haver analytics and GSAM calculations. December 2016 to May 2017 assumes oil price remains unchanged at $45/barrel.
Earnings Up, Costs Up, Equities Up?
A tighter labor market has resulted in steady wage growth, which is weighing on corporate profitability. We are observing this trend across a number of private companies. Private equity managers are finding it increasingly difficult to fill the skill gap in industries such as software and engineering services.
—Michael Brandmeyer, Co-CIO, Alternative Investments and Manager Selection (AIMS)
The effect of inflation on equities is a kaleidoscope of contradictions, making firm conclusions hard to come by. Overall, we think a reflationary environment should be a good thing for equities, especially relative to other asset classes, and we expect modest positive returns to stocks next year.
To an extent, higher inflation is a reflection of better GDP growth, which should benefit revenues. For example, higher wages could support consumption, boosting both growth and company earnings. At a macro level, this has to be weighed against the headwind of higher wage costs for companies and higher expected interest rates, which will also arise from more inflation. Unlike bonds, equities have the ability to grow their cash flows and, assuming rising rates are met with improved economic growth, earnings growth typically outstrips the negative impact on rising cost of capital. Additionally, many management teams have been mindful of the rate risk posed to their businesses and have managed their balance sheets accordingly by fixing and terming out their debt such that, even when rates rise, it will take quite some time for it to filter into a rising cost of capital. By our estimates, equities can potentially withstand yields at the 10-year point around 2.8% without compromising valuations.
The distribution of tail- and headwinds matters across equity sectors and company margins. Likewise, higher commodity prices may reflect demand growth, but for companies represent a drag on earnings. We think that companies with pricing power to pass on such cost pressures should benefit relative to those for whom margins could come under pressure. Already purchasing manager survey data in the US shows both input and output prices rising at the end of 2016.
We think inflation trends, and the likelihood of tighter monetary policy in response, suggest US interest rates will continue to rise in 2017. Different sectors of the equity market will likely respond differently to the rising rate environment that higher inflation will prompt. Financial stocks may outperform, while stocks that have historically offered higher income or lower volatility (e.g., utilities or consumer staples) may underperform broader equities. Real estate investment trusts (REITs) could come under pressure, but we expect some offset as rising inflation leads to rising rents (in contrast to the negative effect that inflation could have on consumer staples via rising input costs).
Equities Prefer Moderate Changes in Inflation
Source: Bloomberg, Haver analytics and GSAM Calculations. Represents time period from 1982 to 2015. These examples are for illustrative purposes only and are not actual results. If any assumptions used do not prove to be true, results may vary substantially. Past performance does not guarantee future results, which may vary.
Could Rates Become the Risk Asset?
The shift in investor focus from deflation to inflation likely reflects a healthy evolution of this economic cycle. However, uncertainty with respect to the level and volatility of real yields and inflation expectations will generate investment opportunities.
—Raymond Chan, Head of Markets Team, Global Portfolio Solutions
Market expectations of a more inflationary environment—coupled with improving growth and a shift from monetary policy stimulus to fiscal stimulus—have driven interest rates higher. We expect the rising-rate trend to continue in 2017, and to exceed what is currently priced into markets. This has several implications.
First, if rates rise in a disorderly fashion, volatility is likely to increase across many markets. This could be driven either by markets anticipating aggressive tightening policy or by Fed hikes that exceed expectations. So far, credit markets have resisted the rise in yields seen since the summer and spreads have remained tight. We expect them to remain range-bound and see them as essentially fairly valued given the current macro environment. However, an abrupt re-pricing of rate markets could change that, and a disorderly unwinding of credit positioning, especially in the mutual fund space, could cause a technically-driven selloff. This could occur across both investment grade and high yield bonds.
Second, higher rates in the US may encourage the dollar to continue its recent surge. A stronger dollar is often a drag for US companies—many of which have substantial overseas operations—and US economic growth overall. Dollar strength may also pose a challenge for emerging markets with high dollar-based funding requirements; higher interest rates present an additional burden here (see “Taper Tantrum 2.0”).
The final, broader, implication follows from the notion that rising rates could cause volatility. Bonds are normally used in portfolios to diversify riskier asset holdings. If a bond sell-off were to cause risk asset prices to fall, that negative, diversifying correlation is lost and investors will have to search in different places for allocations that can hedge risk positions. Some of that behavior can be seen by looking at the chart of correlations between equities and bonds which turned positive after the summer, similar to the “Taper Tantrum” of 2013.
Higher Stock-Bond Correlations Have Historically Undermined Diversification
Source: Bloomberg and GSAM calculations. Bonds is the Barclays US Government Index, Equities is the S&P 500. As of Nov. 30, 2016. Past correlations are not indicative of future correlations, which may vary. Diversification does not protect an investor from market risk and does not ensure a profit. Past performance does not guarantee future results, which may vary.