Three Dangerous Words for an Investor to Buy Into: Inflation Is Dead
If central banks can’t explain why the economic measure is so low, then why is there so much faith in their forecasts?
Bonds, equities and commodities appear to be sending contradictory messages about the economy, adding to the confusion from central banks struggling with the breakdown of their inflation models. However, the markets can be reconciled—and if they are right, the outlook is just dandy for Wall Street, if not so much for Main Street.
Unfortunately, the failure of central-bank models to predict the yearslong slowdown in global inflation leaves investors in the dark about the most important economic measure today and why it’s so low. If policy makers and economists can’t explain convincingly why inflation is where it is, why are investors putting so much faith in their forecasts of where it will go?
Start with what markets are telling us about the economy. Bonds have become significantly less optimistic this year, and this week futures traders started for the first time to price a—tiny—chance of a Federal Reserve rate cut at this month’s meeting. Yet equity markets are booming, with the S&P 500 just 1% below its all-time high. The price of copper has leapt by a quarter this year and industrial metals more broadly have jumped, suggesting robust demand.
So do the markets think the economic engine is purring along nicely or about to stall? Look below the hood and we can extract some consistency.
The place to start is with the bond yield curve, the extra yield on offer for holding longer-maturity Treasurys. The curve has been flattening and 10-year bonds now offer just 0.77 percentage point more than two-year bonds, usually a bad sign. Yet, while the outlook for growth may not be great, it doesn’t signal immediate trouble, either.
The yield curve is still only as flat as it was in March 2005, February 1996 or July 1988, each of which was followed by S&P 500 gains of at least 20% over the following two years, before recession hit. Recession eventually arrived, after the yield curve turned negative, but for now it’s consistent with the U.S. being in the late stages of the economic cycle.
“People look to the yield curve as the ultimate arbiter and it says you should be taking risk,” says Gregory Peters, senior investment officer of PGIM Fixed Income in New York.
Headline equities may not seem to fit this story, but look a bit closer and they do. The market is being held up by so-called growth stocks, less reliant on economic expansion for profits than on new technology and business models. The Russell 1000 growth index has outperformed value by 14 percentage points this year, an eight-month performance last beaten in the post-Lehman recovery and before that during the dot-com boom. Shares in big companies are beating small as well, which has happened in the late stages of previous economic cycles, too.
Metals are trickier, because they’ve changed from the days when investors used to joke that Dr. Copper was the only metal with a Ph.D. in economics. The rise in the price of copper and other industrial metals does tell us that the economy is picking up—but in China, not the U.S.
Krishna Memani, chief investment officer of OppenheimerFunds, says to stick with what’s worked: either look outside the U.S., or in the U.S., stick to larger growth stocks rather than shares dependent on faster economic growth.
“What the long end [of the bond market] is really telling you more than anything else is that inflation and inflation expectations are nonexistent,” he says. The Federal Reserve, he thinks, should “just sit back and enjoy” the prospect of growth without inflation.
The danger is that this low-inflation consensus has grown far too strong, on too little evidence. Sure, inflation has been weaker than economic models predicted for a long time. But without a decent explanation for why, forecasts of low inflation look like a classic case of recency bias, the tendency to look to the recent past for guidance.
The European Central Bank’s predictions on Thursday perfectly fitted the pattern. Eurozone growth this year is now forecast to be the fastest since before the 2008 crisis, while inflation was revised down and will probably reach the target of just under 2% only in 2020, ECB President Mario Draghi said.
Investors should examine their assumptions. How sure are they that they really understand what’s driving inflation? Adding together the effects of labor-market structures, globalization, declining union power, technology and monopolistic behavior, among much else, is something that’s proven too hard for central banks. Why trust their or anyone else’s predictions?
The markets want to believe the economy will stay in the sweet spot, growing just enough to avoid deflation concerns while avoiding pushing up inflation. But wanting something to be true don’t make it so. Investors should pay more attention to the risk of a less-perfect future, and the best way is to lighten up on the growth stocks, which have made them so much money recently, and hold fewer Treasurys than usual.