Inflation matters
Witold Bahrke, Senior Macro Strategist at Nordea Asset Management

Inflation has fallen year to date, contrary to most analysts’ expectations. Although inflation is unlikely to fall much further in the main economies, it is hard to see a paradigm shift away from “lowflation” when looking ahead. In a low growth environment, this is good news for bonds — and maybe for equities as well.

Inflation matters a great deal for investors. Together with growth it is the main building block for the stylized investment framework known as the investment clock. A brief reminder: The investment clock divides the macroeconomic backdrop in high/low growth and high/low inflation. If one can identify which combination of growth and inflation we currently are experiencing, he will have a clear idea of which asset classes should perform best. Consequently, inflation matters not only for macro nerds, but is front and center when developing a view on markets and asset classes.

In the first half of the year, a weakening global inflation picture surprised most analysts and central bankers – they expected exactly the opposite, namely an exit from the long-lasting lowflation environment. Annual price increases generally fell in the biggest economies year to date and are now significantly below most central banks’ targets of around 2%. US annual consumer price inflation fell from 2% in January to 1.4% in August. In this context, the historical average of 3.3% seems almost staggering. Although with slightly different levels as starting points, the same story could have been told about Euro Area Inflation.

The recent price statistics do not indicate outright deflation, but definitively show a sobering outcome for the numerous market participants expecting inflation to rise in 2017. It is somewhat at odds with a benign global economic environment famously labelled “synchronised global recovery” by the analyst community. All else being equal, an economic recovery should also result in higher prices, albeit with a time lag. But is the low level of inflation really that surprising – and what does it mean for the inflation outlook in the quarters to come? This is one of the key questions for investors, we believe.

The recent fall in inflation is reflecting a weakening in both cyclical and structural drivers. Mainly as a result of falling energy and commodity prices, year over year price increases came down cyclically. Despite a strong labour market, the structural trend in inflation weakened as well. This is a bit more puzzling, as a strong labour market and low unemployment rate text book-wise implies inflation should creep up as well. Not so this time around.

Persisting forces are preventing inflation from rising structurally. Just to name a few factors: An ageing labour market means people are on average less productive. This also means that their compensation does not rise as fast as it did before. On the technological front, robotics reduce the demand for labour. The legacy of the Great Financial Crisis, namely very elevated debt levels, plays an important role as well. Highly indebted employees are less willing to take much risk in wage negotiations or with respect to job changes. One might have hoped that debt burdens would decrease as the year passed—to the contrary: US household debt has recently surpassed pre-crisis highs. Also, globalisation and technological changes have favoured lower-paying jobs rather than middle-class jobs. All of these structural factors prevent inflation from rising on a more permanent basis.

Despite the headwinds to inflation, central banks have not come to the rescue. Ultra loose monetary policy following the Great Financial Crisis should, according to the textbooks, have pushed up inflation, at least cyclically. But the only inflation central banks have managed to create is asset price inflation, as quantitative easing has pushed up prices for a wide range of assets. The net result: Rising financial risks, income inequality and political risks instead of “back-to-normal” inflation.

So both the structural as well the cyclical fall in inflation rates are not so mysterious after all. While inflation in the biggest economies might not fall much further anytime soon if our outlook materialises, it is also unlikely to rise back above central banks magic 2% target. Although central banks have a hard time acknowledging this for credibility reasons, investors should get used to a lower equilibrium inflation rate. As such, it is a manifestation that we are not seeing a paradigm shift out of the lowflation environment dominating the post-crisis era. For bond investors, this is undoubtedly good news, as it translates into a lower equilibrium interest rate path as well and limits the downside in core bonds – despite rich valuations.

Low inflation needn’t  be bad for equity investors either, at least from an all-else-being-equal perspective. In a low potential growth world, higher inflation would lead to a stagflationary environment rather than reflecting a pick-up in demand. It would drive up wages and interest rates without growth lifting off. In other words, it squeezes companies’ profits and forces central banks to tighten. It would most likely be the beginning of the end of the equity bull market. Equity investors should therefore be careful what inflation they wish for. All else of course is not equal. Hence, in a classic investment clock set-up the fate of equities also depends on what happens with growth, and – crucially – whether low growth then is priced into equities or not. But this is a different question.

About Nordea Asset Management
Nordea Asset Management (NAM, AuM 219 bn EUR*), is part of the Nordea Group, the largest financial services group in Northern Europe (AuM 332 bn EUR*). NAM offers European and global investors exposure to a broad set of investment funds. We serve a wide range of clients and distributors which include banks, asset managers, independent financial advisors and insurance companies.

Nordea Asset Management has a presence in Cologne, Copenhagen, Frankfurt, Helsinki, London, Luxembourg, Madrid, Milan, New York, Oslo, Paris, Sao Paulo, Singapore, Stockholm, Vienna and Zurich. Nordea’s local presence goes hand in hand with the objective of being accessible and offering the best service to clients.

Nordea’s success is based on a sustainable and unique multi-boutique approach that combines the expertise of specialised internal boutiques with exclusive external competences allowing us to deliver alpha in a stable way for the benefit of our clients.  NAM solutions cover all asset classes from fixed income and equity to multi asset solutions, and manage local and European as well as US, global and emerging market products.

*Source: Nordea Investment Funds, S.A., 30.06.2017

Nordea Asset Management is the functional name of the asset management business conducted by the legal entities Nordea Investment Funds S.A., Nordea Funds Ltd and Nordea Investment Management AB (“the Legal Entities”) and their branches, subsidiaries and affiliated companies. This document is intended to provide the reader with information on Nordea’s specific capabilities. This document (or any views or opinions expressed in this document) does not amount to an investment advice nor does it constitute a recommendation to invest in any financial product, investment structure or instrument, to enter into or unwind any transaction or to participate in any particular trading strategy. This document is not an offer to buy or sell, or a solicitation of an offer to buy or sell any security or instruments or to participate to any such trading strategy. Any such offering may be made only by an Offering Memorandum, or any similar contractual arrangement. Consequently, the information contained herein will be superseded in its entirety by such Offering Memorandum or contractual arrangement in its final form. Any investment decision should therefore only be based on the final legal documentation, without limitation and if applicable, Offering Memorandum, contractual arrangement, any relevant prospectus and the latest key investor information document (where applicable) relating to the investment. The appropriateness of an investment or strategy will depend on an investor’s full circumstances and objectives. Nordea Investment Management recommends that investors independently evaluate particular investments and strategies as well as encourages investors to seek the advice of independent financial advisors when deemed relevant by the investor. Any products, securities, instruments or strategies discussed in this document may not be suitable for all investors. This document contains information which has been taken from a number of sources. While the information herein is considered to be correct, no representation or warranty can be given on the ultimate accuracy or completeness of such information and investors may use further sources to form a well-informed investment decision. Prospective investors or counterparties should discuss with their professional tax, legal, accounting and other adviser(s) with regards to the potential effect of any investment that they may enter into, including the possible risks and benefits of such investment. Prospective investors or counterparties should also fully understand the potential investment and ascertain that they have made an independent assessment of the appropriateness of such potential investment, based solely on their own intentions and ambitions. Investments in derivative and foreign exchange related transactions may be subject to significant fluctuations which may affect the value of an investment. Investments in Emerging Markets involve a higher element of risk. The value of the investment can greatly fluctuate and cannot be ensured. Investments in equity and debt instruments issued by banks could bear the risk of being subject to the bail-in mechanism (meaning that equity and debt instruments could be written down in order to ensure that most unsecured creditors of an institution bear appropriate losses) as foreseen in EU Directive 2014/59/EU. Published and created by the Legal Entities adherent to Nordea Asset Management. The Legal Entities are licensed and supervised by the Financial Supervisory Authority in Sweden, Finland and Luxembourg respectively. The Legal Entities’ branches, subsidiaries and affiliated companies are licensed as well as regulated by their local financial supervisory authority in their respective country of domiciliation. Source (unless otherwise stated): Nordea Investment Fund, S.A.  Unless otherwise stated, all views expressed are those of the Legal Entities adherent to Nordea Asset Management and any of the Legal Entities’ branches, subsidiaries and affiliated companies. This document may not be reproduced or circulated without prior permission. This document is furnished on a confidential basis and may not be reproduced or circulated without prior permission and must not be passed to private investors or any investors not covered by relevant regulation. This document contains information only intended for professional investors and eligible investors and is not intended for general publication. Reference to companies or other investments mentioned within this document should not be construed as a recommendation to the investor to buy or sell the same, but is included for the purpose of illustration. The level of tax benefits and liabilities will depend on individual circumstances and may be subject to change in the future. © The Legal Entities adherent to Nordea Asset Management and any of the Legal Entities’ branches, subsidiaries and/or affiliated companies.

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