Despite a year of shock results and surprises, the U.S. economy is displaying positive momentum. Survey and sentiment data remain strong, aided by expected growth in the energy and manufacturing sectors, despite a few bumps in the road from hard numbers, such as auto sales and construction figures. Whether President Donald Trump's infrastructure plans come into effect this year, animal spirits have been rekindled by his rally calls. But there is one factor returning to view to provide a challenge for the whole of the nation: Inflation is on the up.
Data are showing a gradual increase in prices, particularly in the U.S., where year-on-year inflation increased steadily through 2016 and into 2017. It is now approaching the Federal Reserve Board's desired 2% level. Looking past the volatile food and energy components, service sector inflation has been creeping upward for more than 12 months. This is most evident in the medical sector, where care services cannot be outsourced abroad. In the labor markets, the industries so hard hit by the tumble in oil prices have started to rehire, with this increased demand for workers across retail, construction and the oil industry itself adding to inflationary pressures. On some measures the U.S. labor market is as tight as it was in 2006.
In Europe, inflation is coming off a very low base, but higher economic activity is pushing levels up nevertheless. The U.K. is vulnerable on the back of currency weakness, although the domestic economy has proven surprisingly resilient since the Brexit referendum.
Despite the global trend, our view is that these indications do not suggest we are facing a shock environment of persistently elevated inflation, but rather, a more nuanced state of gradually increasing levels. Central banks are clearly following the trend closely and moving into position to act decisively on rising inflation via rate hikes — looking to normalize the rates environment sooner than later. We anticipate seeing two to three hikes by the Fed in 2017 in an attempt to catch policy up with shifting economics. For already pressed fixed-income markets, these increases should come as further blows, pushing up yields and leading to losses in many portfolios that rely on traditional Treasury allocations. Investors need to act now.