Missing the cut; tales from the rough

The plan was to link to my latest cameo on Bloomberg TV, but on a busy news day I didn't make the cut to get a clip on their website. Undeterred, here's summary of what we covered on oil, US unemployment and inflation.

The plan was simple. Visit the New York Bloomberg studio while working in the US, explain our latest thinking and then follow up with a link on the blog to the interview. But you know what they say about best laid plans... Not all interviews get captured as clips on Bloomberg's website and this time I didn't make the grade, so I've reverted to a written summary of the main points discussed.


An oil condor

The US’ Syrian strikes were touted as a key driver of higher oil prices last week, but I would question this narrative. Circumstances where Middle East tension could drive oil prices down are rare, about as rare as a Condor in golf, but in this instance it increases the risks around whether OPEC and Russia extend their coordinated production cuts past May, which is our base case. Extending the cuts requires Russia, Saudi Arabia and Iran to work together, which is more difficult as the Syrian tensions escalate, and as Saudi Arabia is generally supportive of the US’ stance and actions. Without this extension, key players are likely to return to maximising market share against the backdrop of higher US shale production, with very serious potential risks to prices.

Trapped in the deflationary bunker 

US unemployment fell to just 4.5% last week, only 0.1% above the lows reached in 2006-2007 before the global financial crisis. While that’s good news for the economy generally, it leaves economists questioning why there hasn’t been more US wage inflation. 

Our economists have spent a lot of time trying to unpick the puzzle, most recently highlighting that falling commodity prices may have reduced pressure on wages to rise, as employees already feel happy about lower prices. From a structural perspective, a particularly compelling argument in my opinion is that official inflation figures are overstated (see James Carrick's Bean Counter note); if the impact is increasing with digitisation and globalisation of the economy (which seems reasonable to me) then it could explain the lack of productivity too, because if inflation is overestimated, then productivity is underestimated and real wage gains are better than calculated, reducing the incentive to bargain for higher wages.


If consumers are experiencing lower inflation than the official figures, then they’ll feel better off than the official real income gains suggest and also have a more deflationary mindset, with less interest in bargaining for higher wages and more interest in job security and maintaining current incomes. 


Under this theory, countries will have to work much harder in future to generate wage inflation than expected by a standard framework, repeating what we've seen in the US. It would also mean a lot more of the policies in the last few years should have been much more directly targeted at raising inflation rates rather than assuming that cutting unemployment would do the trick - so focusing on nominal growth. This could actually make inflationary policies, such as those embraced by President Trump, a positive in shifting mindsets and escaping the deflationary sand trap that economies seem to be in. This offers a positive spin on the concerns Tim Drayson has already outlined around any stimulus at this stage of the economic cycle.  

 We still think that US inflation-linked bonds offer the most attractive hedge for the risk of normalisation

Finding the fairway

The US is the closest to normalising policy, with three rate hikes under its belt, but the general expectation is that other regions can ultimately follow their lead. However, the US has been prepared to maintain stimulus while pushing unemployment below the Fed’s own estimates of the sustainable rate (their estimate of the NAIRU (Non-Accelerating Inflation Rate of Unemployment) is 4.7%). In Europe there is likely less political will, which increases the risk of a policy mistake, with stimulus potentially being withdrawn too early.


Therefore, despite a pick-up in US inflation expectations, we still think that US inflation-linked bonds offer the most attractive hedge for the risk of normalisation. Rates implied by US TIPS for 5-10 years’ time are still lower than almost all of the period from 2002-2014, despite the US inflation rate creeping up towards target (Personal Consumer Expenditure inflation was 1.8% on the latest reading against a target of 2%). Investors can effectively hedge inflation risk without paying a premium for doing so. This is surprising given that ultimately most investors should care about inflation-adjusted outcomes and so intuitively be prepared to pay a premium to protect them.

Elsewhere, we believe the absence of inflation is set to prevail. For example, in the Eurozone our European economist Hetal Mehta isn’t expecting core inflation to creep up towards target within our 2-3 year forecasting time horizon. Therefore, in Europe we continue to prefer to take any inflation exposure through real assets with more upside growth potential, while keeping our bond exposure focused on nominal bonds.