The good times roll on. Risk assets remain on a firm footing, underpinned by solid expectations for growth in both advanced and emerging economies in the year ahead. The monetary policy backdrop in developed markets also remains supportive of risk-taking, as weak inflation readings suggest that any withdrawal of policy accommodation will be extremely gradual. Meanwhile a number of potential risk-off catalysts have barely made a dent in investor risk appetite, including elevated tensions between the United States and North Korea, and the standoff between the Spanish government and an increasingly restive independence movement in Catalonia. Instead, markets remain firmly focused on positive macroeconomic fundamentals and the longer-term investment implications of a low-rate, low inflation environment.
Given the high level of animal spirits and the ever-widening search for returns, this seems an opportune time to step back and ask, what events could throw the market bulls off course even if global growth expectations are met? One obvious culprit would be a material shift higher in developed market sovereign bond yields. As such, this quarterly takes a different approach from past offerings, as we share views on some of the possible catalysts for higher yields and how likely they are to come about. In particular, we focus on the inflation outlook, the potential for increased supply as a result of central bank balance sheet normalization and fiscal stimulus, and upside growth surprises.
Inflation – the dog that won’t bark
We see little prospect for a material increase in global inflation over the next year, and equally low prospects for central banks sustaining inflation at their targets in the years ahead. First and foremost, the aggregate global output gap still remains in negative territory almost a decade after the financial crisis, suggesting little pressure on resource utilization. Even in countries such as the United States where the labor market is moving past full employment conditions, the globalization of labor supply and the threat that technology poses to job security have served to weaken wage bargaining power, limiting the prospects for cost-push inflation. And while it may be hard to see in academic studies, we have to believe that the expanded consumer opportunity set and price transparency brought about by online shopping are also limiting factors on inflation. Finally, we see few prospects for oil prices to move significantly higher, given the global supply shock resulting from the US shale revolution. A supply-limiting OPEC with high fiscal breakevens for oil prices has been replaced by an increasingly efficient US shale complex as the swing producer.
In addition to a number of structural forces that continue to pull global inflation levels down, recent actions of some developed market central banks may be contributing to weak inflation. Despite somewhat accommodative policy stances, neither the Federal Reserve nor European Central Bank appears serious about hitting their inflation targets. The former is tightening policy even as the United States has experienced disinflation this year and Chair Yellen acknowledges that the inflation shortfall has been “somewhat of a mystery.” The European Central Bank, meanwhile, has signaled further tapering of its asset purchases, accepting chronically below-target inflation so long as deflation risks are well-contained. More broadly, the very policy of low rates and financial repression has caused an unabated demand for higher yield investments, even those that are less fundamentally sound. This has led to zombie firms that under normal lending conditions would otherwise find it difficult to finance themselves. By staying in business, they boost competition more than would be the case, leaving many firms unable to raise prices.
On one level, the relatively relaxed attitude to below-target inflation is understandable – historically, inflation overshoots have presented the more significant economic challenges in both economies, and there could be popular and political opposition to more aggressive attempts to push prices higher. Financial stability risks could also rise if policy were to remain overly accommodative for an extended period. But on the other side of the ledger, low-inflation in good times increases the risks of deflation in the next recession, particularly when a return to the lower interest rate bound will leave central banks with a constrained set of choices for adding stimulus. And if central banks currently are demonstrating a weak commitment to their inflation objective, the credibility of future commitments – such as outcome-based forward guidance in a future recession – will be called into question.Download to read more