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Should Inflationary Expectations Be So Sticky?

Capital markets have brought lots of surprises this year. Two developments especially – recovering commodity markets and a falling US dollar – have important implications for future consumer prices.

Capital market participants do not seem overly sensitive to these two developments in terms of expectations of future inflation.   Commodity prices are for the most part an “input” into the type of goods and services consumed.  The US dollar on the other hand acts as a translator of value between goods produced abroad and domestic consumers.

Recent consumer price changes have been muted in the last few years.  Monetary authorities in the US as well as abroad seem particularly troubled by the prospect of deflation and have in some cases even resorted to the use of negative policy rates to revive growth.

The April 14 BLS Report on the CPI-U estimates year-over-year inflation at just 0.9%.  This number is welcome news after near zero inflation for most of 2015, but still lags the historical norm of 3% annual inflation by a wide margin.

CPI BREAKDOWN APRIL 2016A quick glance at the latest report provides interesting clues.  Two of the four main categories of consumption categories – Food, Energy, Commodities Less Food & Energy, and Services – exhibit price depreciation over the last year.

The biggest deflationary force has been the Energy category with a 12.6% price drop.  The other deflationary category is Commodities Less Food & Energy with a -0.4% year-over-year price change.

Federal Reserve members seem concerned with the possibility of deflation in the US, but what about market participants?  We evaluate two measures – the breakeven rates from TIP prices measuring the expected inflation over the next 5 years (orange line) and the so called 5-over-5 rates measuring inflation expectations five years from now over the next five years (green line). To provide context we also illustrate the rolling year-over-year CPI-U inflation.

infl expt april 2016

Capital market participants are expecting an uptick to inflation, but in light of this year’s commodity price increases and the depreciation of the US dollar do these expectations need to be revised? Yes, the market implied inflationary expectations seem low in relation to the resurgence in commodity prices and the depreciation of the US dollar.

Where do we see inflationary expectations heading to?  Our research based on our econometric model of 5 year inflationary expectations calls for steady but moderate upward revisions.

BE5 INFL PREDICTIONSThe latest market-based estimate of 1.61% is expected according to our model to rise to 1.7% by the end of Q2 and to 1.9% by the end of the year.

We are not expecting a huge bump up yet in inflationary expectations in large part due to the fact that rising commodity prices and a depreciating USD have only been in place for a short period of time.

Many strategists are still skeptical that these two trends have legs.  Our view is that even if there is no further change for the remainder of the year inflationary expectations have been too low and will slowly drift up.

What are the implications for investors of slowly rising inflationary expectations?  For now the more direct impact for investors of rising commodity prices and a falling US dollar is being felt through the rise of previously unloved sectors such as Energy and Materials as well as the revival of Emerging Market Equities.

The transmission mechanism from higher commodity prices and changes in the value of the US dollar to actual inflation pressures is not immediate of for that manner always straightforward as many other forces such as demographics and the overall health of the global economy come to bear.

Rising inflationary expectations would according to our risk management methodology benefit holders of risky assets such as equities, commodities and real estate.  Safer assets such as bonds would suffer as we would expect higher inflationary expectations to translate to higher nominal interest rates.  The effect would obviously be greater the longer the duration of the assets.

Click here to download the report: Should Inflationary Expectations Be So Sticky

 

Sincerely,

Eric J. Weigel
Managing Partner and Founder of Global Focus Capital LLC

eweigel@gf-cap.com

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