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The wrong sort of inflation

Rising inflation expectations have been bad for equities so far this year, but markets might be worrying unnecessarily
March 13, 2018

Inflation is no longer good for equities. That’s the message of the fact that inflation expectations (as measured by the gap between the yield on five-year gilts and their index-linked counterparts) have risen so far this year while the All-Share index has fallen.

Such a development overturns the pattern of most of the past 10 years. During this time, there’s been a strong positive correlation between inflation expectations and share prices. Falls in inflation expectations in 2008 and 2015 were accompanied by falls in share prices, and rising inflation expectations in 2009, 2013 and 2016 saw shares rise. Which poses the question. What’s changed?

The answer lies in a distinction between 'early cycle' and 'late cycle' inflation (the term 'economic cycle' is often misleading, but it’s useful in this context).

The rises in inflation expectations in 2009 – and to a lesser extent 2013 and 2016 – were 'early cycle'. They were associated with expectations of better economic growth, something that is naturally good for shares. Conversely, the falls in inflation expectations in 2008 and 2015 were accompanied by fears of weaker growth, which hit equities. Variations in inflation expectations, then, have been positively associated with equity returns because they have been accompanied by variations in expectations of economic growth.

The latest rise in inflation expectations, however, is different. It is associated not with hopes of faster economic growth, but with the opposite – a fear that growth might slow as central banks raise interest rates to curb those incipient inflationary pressures. Stock markets like 'early cycle' inflation as it’s associated with optimism about growth. But they hate 'late cycle' inflation as it’s associated with higher interest rates and the threat of slower future growth.

 

Such fears aren’t wholly without merit. The CBI recently reported increasing skill shortages and said that the proportion of companies with spare capacity is at a 29-year low. Add to this the fact that the unemployment rate is at its lowest since 1975 and we have a clear danger: not only are there physical barriers to growth caused by shortages of labour and capacity, but also a danger that these shortages will push up wages and prices. That’s classic 'late cycle' economics. 

But we also have reasons for optimism. For one thing, sterling has risen by over 5 per cent on its trade-weighted index since September. This should reduce import prices while the threat of stiffer price competition from overseas should stop some UK companies from raising prices. Also, commodity prices have fallen since mid-January and they might continue to do so, given that monetary growth in China has slowed recently: this has in the past been a good lead indicator of the country’s output growth. And although wage inflation is now edging up, it is doing so only gently.

Better still, labour productivity is now growing strongly. It rose 0.8 per cent in the fourth quarter after a 0.9 per cent rise in the third. It seems, therefore, that capacity constraints and labour shortages are forcing companies to increase their efficiency rather than raise prices.

If this can continue, it would be fantastic for equities. It means growth might continue not because companies will hire more workers, but because they’ll get more out of their existing workforces. And if productivity rises, higher wage inflation (even if it materialises) need not lead to price rises because it’ll be paid for by efficiency gains. In other words, we might not be at the late stage of the 'economic cycle' at all. Equity investors fears, therefore, might not materialise.

Of course, it’s not certain that productivity will continue to grow – and certainly not at its recent high rate. And there are strong reasons to fear that growth will be poor: a rebuilding of household savings, ongoing fiscal austerity and uncertainty about Brexit being among them. It’s far from clear, though, that higher inflation is among these obstacles to growth. On this score, investors might be worrying unnecessarily.