Low and steady inflation has been a central feature of global economic performance for the past 15 years. In this article, we will look at some of the drivers of global inflation and the implications for fixed-income investing in 2018.
Before the financial crisis, global headline inflation cycled around 3%. After showing some volatility during the crisis, reflecting sharp moves in commodity prices and the severe economic downturn, aggregate headline inflation stepped down to around 2% – and moved a bit lower through much of the past two years. Similarly, global core inflation trended down during the first half of the last decade, but then stabilized near 2% post-crisis.
Given the divergent economic conditions before and after the financial crisis, these similarities are striking. The pre-crisis period saw rapid growth, building leverage in the financial system and overheating asset markets. The post-crisis period has seen softer growth and a gradual reduction of very high unemployment rates. Financial markets have been on a recovering trajectory, but there is now much less leverage in the core of the system. In addition, during both periods inflation has typically shown little sensitivity to the unemployment rate – the Phillips curve has been very flat.
What's driving global inflation?
To tackle this question, we examined inflation in 18 advanced and emerging-market economies for two time periods – the first quarter of 2002 through the second quarter of 2007 and the first quarter of 2012 through the second quarter of 2017. These economies together account for roughly 85% of global GDP.
We found that in advanced economies, inflation has been remarkably stable. Headline inflation has moved down some, in line with the drop in commodity prices. But the distribution of outcomes for core inflation (i.e., excluding food and energy) – judged by both mean and standard deviations – looks very similar in both periods. Notably, Japan accounts for all but one observation in negative territory.
We then considered how well the observed distribution aligned with central banks' policy objectives. Several observations seem relevant.
First, central banks have clearly been successful in their long-term effort to prevent inflation from breaking out on the upside. Second, except for Japan, central banks have been successful in avoiding deflation. Bank of Japan Governor Haruhiko Kuroda's efforts seem to be gaining traction, but the challenges have been daunting. Third, the center of the distribution of inflation outcomes (whether judged by mean or median) has come in near 1.5%, rather than at 2%, particularly in the second period, leading us to question whether hitting a target with greater precision is achievable as a practical matter.
Inflation in the major emerging markets is split into two groups. Countries with relatively high inflation pre-crisis – Turkey, Russia and Indonesia – have achieved lower inflation since then, although Turkey has given back some gains over the past two years. Other economies have seen fairly stable inflation – much like the advanced economies (albeit with moderately higher average rates and variability). These results are broadly encouraging for emerging markets and confirm their increasing policy maturity and the strength of their core institutions.
The implications of lower inflation and a more moderate economic backdrop for fixed-income investing are manifold.
For starters, a business cycle characterized by growth and inflation remaining at generally lower levels and exhibiting less volatility – with a bit more conservative financial regulation – is likely to lead to lower and less volatile long-term interest rates. The front end of the U.S. Treasury yield curve, however, will continue to be driven by the business cycle and changes in administered rates.
As a result, the yield curve dynamic in the U.S. in 2017 – where short rates rose by roughly 1 percentage point while the 10-year Treasury yield was scarcely changed from its level at the beginning of the year – might become more the rule than the exception. And to the extent that short rates continue to fluctuate widely over the business cycle, while long rates remain generally low and stable, the yield curve may be, on average, flatter and more frequently inverted than it has been in recent decades.
To the extent this plays out, investors and managers that expect steeper curves and higher long-term rates might not have the right approach to playing the yield curve. Furthermore, those who assume yield curve flattening is a signal of impending economic slowdown might get the wrong read on the economy, and end up wrong-footed on asset allocation and intersector positioning.
The more moderate macro backdrop may translate into a longer business cycle. Already, the current practice of cautious, yet pre-emptive, central banking has delivered nearly a decade of U.S. economic expansion. In terms of fixed-income portfolio management, this sort of longer, milder business cycle has, and may continue to see, more micro inter- and intrasector allocation opportunities and less frequent major macro spread widening and narrowing incidences. As a result, asset allocation schemes focused on capturing intrasector and issue selection opportunities might prove more successful than those focused on trend reversals at the turning point of the overall business cycle.
Nathan Sheets is chief economist and head of global macroeconomic research and Robert Tipp, chief investment strategist and head of global bonds, at PGIM Fixed Income, Newark, N.J. This article represents the views of the authors. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team. The full white paper is available on PGIM's website.