Have investors jumped the gun in thinking that the era of low inflation is now over?
Jason Hollands, managing director at Tilney Bestinvest, says Yes.
Deep tax cuts, looser banking regulation, massive spending on infrastructure and the military, alongside higher tariffs on imports and tighter immigration restrictions – Donald Trump’s economic policies are inherently inflationary for the US economy, especially against a background of low unemployment.
Global bond markets have reacted dramatically with yields heading north in expectation of a radical shift. Yet there is a possibility that markets have jumped the gun, not least because it is not yet known which of his policies will come to fruition.
One of the risks is that fierce tariffs are placed on Chinese imports – highly damaging for the Chinese economy – and which may prompt an aggressive response in the form of a steep depreciation of the renminbi. China has built up a lot of excess capacity and needs cash flow to service its ballooning debt. A sharp depreciation in its currency could flood the globe with cheap goods, unleashing a deflationary tsunami and damaging countries which don’t have trade firewalls in place to cope.
Ben Lord, fund manager of the M&G UK Inflation Linked Corporate Bond fund, says No.
Barring some unforeseen oil shock, US and UK CPI indices will be above 2 per cent in the first quarter of next year. The question is whether this inflation will be short term or more sustainable.
UK bond markets are priced for RPI to average 3 per cent a year for the next five and 10 years. This implies CPI around 2 per cent on average for the next 10 years. This is not suggestive of a bond market that has got ahead of itself yet.
The UK has full access to the Single Market for the next two and a half years. We have no idea what happens next. If I were running an export company, I would ensure I operate at full capacity for that period. So I am bullish on the UK economy in the short term.
Prices that firms pay for input costs are now rising at a 12.2 per cent higher rate than a year ago. Hedges have expired, and the pass through to consumers is a matter of when, not if. Central bankers are also preparing markets for inflation overshoots. The Fed has stated its tolerance for inflation overshoots and undershoots is symmetric: a big deal for inflation watchers.
So, the bond market has not got ahead of itself, but rather was too keen to price in deflation risk earlier this year. I think we are at the early stages of a pricing out of deflation risk.