Como va el mercado de renta fija

Chris Iggo, AXA IM - Viernes, 21 de Julio

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Despite early  summer hawkishness, it seems central banks are not ready to declare the victory in the fight to restore inflation to target levels. Maybe it remains a question of time – the Phillips curve will eventually kick in with higher wages once unemployment has fallen more, but for the moment policy is on hold until inflation does start to rise. Over the summer, soft headline inflation rates should keep central bankers quiet and bonds will do well. Beyond the headlines though there are forces at work that are generating different inflation rates within developed economies that go beyond the scope of monetary policy that targets the general price level. These trends – disinflation in goods prices, positive inflation in publicly provided services – have distributional implications. Smart phones may be getting cheaper but providing universal healthcare is not and that challenges the management of fiscal and public policy in many developed countries. At the macro level, continued low inflation and the inability of central banks to normalise will mean asset prices continue to be boosted by cheap money. There is a risk in this too.     

• Tightening when they can –  If bond yields are to rise over the coming months one of the drivers will be what I have described as the “opportunistic normalisation” of monetary policy. In late June the Bank for International Settlements (BIS) issued its annual report. In the press release that accompanied the publication of the report, the BIS said that “the current economic upswing provides an opportunity to build greater economic resilience….At a domestic level there is a need to restore policy space” and that the potential for increased debt service costs “highlights the importance of gradual and steady monetary policy normalisation, but also the risk of waiting too long to normalise”. In the days and weeks that followed the publication of the BIS report the tone of monetary policy became more hawkish and global bond yields moved higher as a result. Central bankers want to normalise, they see multiple reasons for normalising and want to communicate effectively with markets about how they will go about normalising. All well and good. Investors expect the Federal Reserve (Fed) to start reducing the size of its balance sheet later this year. They expect the European Central Bank (ECB) to begin tapering bond purchases in 2018 and some participants are even in line with the Bank of England’s (BoE) recent suggestion that last year’s post-referendum rate cut should be reversed. While not exactly singing from the same song sheet, our masters of monetary policy are at least at the same music festival. 
• But a need to wait for inflation –  The problem with “opportunistic normalisation” is that it needs rising inflation – or at least a very strong consensus expectation of rising inflation - to justify the exit from emerging monetary policy settings without upsetting financial markets that have become addicted to super-low interest rates. The release of consumer price inflation data from the US last week highlighted the problem. The annual inflation rate slowed to 1.6% in June, a sharp deceleration from the 2.7% rate seen in February of this year (consumer prices were flat in June and have only risen by 1/10^th of a percent over the last three months.  In two of the first six months of the year, the headline consumer price inflation index has fallen – this only happened once in 2016 and three times in 2015 when global oil and commodity prices were falling sharply).  Annual wage growth has also slowed during the same period. This is not what is supposed to happen in an economy with an unemployment rate of 4.4%. The “BIS consensus” is that inflation will rise as labour markets tighten and it is prudent for central banks to get ahead of the curve in order to prevent financial instability. But what if the model  is wrong? What if, as I have discussed before, monetary policy can’t deliver inflation because of powerful structural reasons why inflation remains so low. If there is no inflation, central banks will back off. Of course, for now, any indication that central banks can’t exit means stocks up, bonds up and credit spreads narrower. In his most recent press conference, Mario Draghi made it quite clear. Inflation is lower than target therefore monetary policy cannot be tightened. Moreover, if inflation falls further monetary policy may have to become even more accommodative.

 

• What went down should go up – It seems to me that monetary policy is struggling to generate a higher overall inflation rate when there are strong structural forces at work impacting  price and wage trends. It is true that the huge amount of spare capacity that was created in the recession created a powerful deflationary phase for the global economy. The consensus view is that as that spare capacity is used up through a recovery supported by very loose monetary policies, these deflationary trends will reverse and inflation will rise back to target levels. We can’t discount this theory, but it is clearly taking time. Perhaps though we need to think just as much about the micro-structural influences on inflation. When you dig into the details of inflation it is possible to see how structural forces are delivering very different inflation rates in different parts of the economy and the consequences go beyond the scope of monetary policy.

 

• Goods and services - For many years now there has been a divergence between goods price inflation and service sector inflation. This is clear in the US and also in the UK, although less so in the euro area. The US durable goods price index peaked in 1996 and has been falling on trend ever since, contributing around -0.18% to the US inflation rate per year since then. Since the end of 1982, the durable goods price index in the US CPI has risen by only 9%. In contrast the services component (excluding the spurious rent of shelter component) has increased by 230% over the same period.  It is the same in the UK. The UK CPI services index has increased by 100% since 1997 while the non-energy industrial goods index has fallen 15%. In between, food and energy inflation are the most volatile parts of the inflation jigsaw and shorter term gyrations in headline inflation rates are generated a lot of the time by what happens with prices for oil and other commodities. None of this is new. We all know that stuff we buy in the shops and, increasingly online, is cheaper and better quality than it was in the past. We experience changes in energy costs on a regular basis, either at the petrol station or through our utility bills. For those that pay privately for healthcare and education, costs keep on going up. Those that rely on the state to pay for healthcare and education increasingly perceive that the quality of service they receive is going down. Of course it is because the inflation rate for education and health has far outstripped the growth in nominal GDP or the ability and willingness of governments to maintain – let alone increase – real levels of expenditure. What some call austerity is really a reflection of the irony of not being able to generate inflation at the macro level at the same time as experiencing a higher level of inflation in a specific sector. Maybe the reason voters are fed up with the reduced quality of public sector services is not because less money is being spent on it but because the cost of provision is rising faster than governments’ ability to pay for it. With an iPhone you get more for your money than you ever did, with healthcare you get less with your (tax) money.

 

• Supply changes- Technology and globalisation are key to the disinflation of global goods in recent decades. They have allowed a constant shift of the supply curve to the right so that the market clearing price has been getting lower and lower. Think about a generic digital device. More and more have been made so the demand for materials, components and distribution has been increasing globally. It seems the supply chains for those materials have continued to be very flexible – just look at the prices of semi-conductors over recent years. Of course, there is always advancement in technology and the constant refreshing of models allows margins to be retained, but the commoditised products get cheaper. The ability of supply curves to move to the right in goods that have a high cheap labour context (clothing) or constantly more powerful technology in either the product or the manufacturing process (durable goods) has driven prices down. There must be bottlenecks that lead to inflation somewhere though? I guess that sits with the human capital, the cost of programmers and developers in Silicon Valley and the related increase in Bay Area real estate prices. As technology companies race to provide more powerful devices, more integrated social media and a more connected “internet of things” the demand for intellectual capital rises. The supply curve there is not so elastic. This is not inflation as we know it because it constitutes a small part of the cost of production for suppliers of technology and the consumer benefits from the fact manufacturing costs are falling all the time.  The demand for technology, particularly at each vintage of commoditised product will become exhausted long before the supply and the supply then has to move on to create a new level of demand with something that not only takes photos but can control your home heating system, monitor your health, feed you and all sorts of things. We can all see this in the technology sector itself but its effects permeate through the entire goods sector, impacting on the cost of production and distribution. Alongside this is the ongoing expansion of global labour supply as increasingly frontier economies are brought into the global trade system. The problem of generating inflation may become even more difficult if, as it seems, parts of the services sector also see disinflation because of the impact of disruptive technologies on price (think Uber).

 

• Not everything is in disinflation – So it is hard to see significant increases in goods price inflation anytime soon, unless politics disrupts, in a bad way, the global trading system. However, there is still inflation in services. Now services cover a broad range of things such as going to the hairdressers, gym membership, airline tickets and healthcare. Importantly it covers the cost of housing too. For many services, the demand curve is quite inelastic which means that when prices go up, demand does not fall that much because consumers need to have them. Healthcare is interesting. In a predominantly privately supplied market like the United States, the price consumers pay for healthcare is partly through insurance premiums and partly directly to healthcare providers. Healthcare inflation has ran way ahead of wage inflation for a long time so consumers feel the pain of higher prices directly through higher premiums and higher doctors’ bills. In a predominantly public healthcare system like the UK, the cost is borne mostly by the tax payer and if taxes don’t rise, it inevitably leads to a deterioration in quality and a fiscal need to limit employment costs. On average health care costs have risen by 3.8% per year for the last 20 years in the UK compared to 2.4% for the overall inflation rate (it is not only the change in price that is important for the fiscal burden, but the volume of provision as well which is important in the context of ageing societies and where immigration has added to patient numbers). Why is healthcare inflation so high? The supply of skilled labour, new drugs and equipment is constrained by the length and cost of training doctors and nurses, the lengthy research and development lags and regulatory barriers to the deployment of new drugs and the constraints on capital investment for buildings and machinery. All the while demand has been growing as life expectancy and “healthcare expectations” have increased. In the UK, housing is another “service” that has had much higher inflation than the general rate. This inflation has distributional consequences and again is driven  by the particularly rigid supply and distribution of physical housing and capital, particularly for lower income cohorts. Where the supply curve is constrained, inflation is higher, where it is flexible, prices tend to fall.

 

• What if inflation stays low? – Macroeconomists will argue that these sectorial trends are interesting but the general price level – i.e. the overall inflation rate – is still determined by the level of aggregate demand relative to supply. Boosting demand through very accommodative monetary policy will eventually close the output gap and lead to higher wages and prices. An argument could be made, however, that specific supply and demand dynamics in different sectors of the economy determine specific inflation rates and these forces are so strong that they dominate over macro trends.  So far, rather than delivering a broad increase in the general inflation rate, central bank policies have had the (not entirely unpredictable) effect of raising asset prices. There are clear distributional implications from all of this. Asset owners have benefitted from increased equity, bond and real estate valuations. Wage growth has been constrained by increased global competition and fiscal constraints, such that the growth in real living standards has slowed, particularly where public service provision has been constrained. Where could it all end? In a horrible mess I suspect. Asset price busts can’t be far away if rates are kept down because there is no generalised inflation. Real income growth remains constrained as companies want to contain wage costs when there is no pricing power. The replacement of labour costs with technology constrains wage growth. The inevitable political response might be to spend more tax revenue on public services to raise both the standard of provision (i.e. keep pace with health and education inflation) and appease the political concerns of those in society that have not seen wage growth.  

 

• In the short term oil is important – I haven’t mentioned food and energy. These are the most volatile components of inflation and tend to dominate shorter term trends in inflation. It could be that the recent soft patch in US inflation reflects weaker oil prices and it may be that the general level of inflation could continue to be lower than central banks would like because oil prices are tending towards the lower end of their recent range. Excess supply has been the determinant of oil prices and there is little monetary policy can do there. A drop in oil prices from current levels could set off a re-run of 2015, delaying any move to tighten global monetary policy because of the impact this would have on global headline inflation and on the energy producing parts of the global economy. It seems likely that lower oil prices will put downward pressure on global headline inflation in the months ahead, making it hard for any central bank to tighten before Q4. Sentiment in the bond market regarding the near term outlook for monetary policy will depend on how central bankers communicate on what may be a temporary dip in inflation against the longer term desire to normalise policy. Judging by President Draghi’s comments last Thursday, dovishness is likely to prevail over the summer.

 

• Supply side reform to boost wages and re-balance inflation – Service sector inflation has been more than offset by ongoing disinflation across a range of non-energy consumer and industrial goods. The overall low rate of inflation that has resulted has allowed wage costs to be kept down. For some this has meant no real income growth and a decline in real living standards particularly when there is a reliance on public services. Policy makers have focused on trying to raise the general inflation rate. However, central bankers have no mandate to address distribution issues in society but their actions have arguably had distributional unintended consequences. If inflation and, therefore, wage inflation is going to stay low, the political choices are limited for governments. Real income could be boosted by one-off tax cuts but that makes financing inflationary public services more difficult. Higher fiscal deficits are likely I suspect. Over the longer term the challenge is to create well paid jobs in economies that become increasingly digitalised and of course that requires investing in the infrastructure of technology (extensive high speed broadband networks) and in education to increase the supply of intellectual capital. In the case of sectors like healthcare, steps have to be taken to slow inflation down and that again means more investment in technology and research as well as reforming the oligopolistic nature of the pharmaceuticals industry. A recent study claimed the UK National Health Service was the best in the world but domestic politics in the UK is dominated by the argument over whether to spend more money on it or not. I think that argument won’t go away as long as the cost of provision runs ahead of the nation’s ability to maintain real spending levels.

 

• Higher yields face tremendous obstacles still – What does all this mean for the bond market? My three forces for higher bond yields – “opportunistic normalisation”, the strength of the cycle and the end of austerity remain valid. However, the first two are somewhat interdependent. Central banks will only tighten if there is inflation and the risk is that the cycle is not strong enough yet to allow the macro dynamics (rising aggregate demand) to overwhelm the micro forces (the shift of supply curves as a result of technology). The risk is this takes longer than thought so rates stay lower and financial markets continue to be fed by cheap money. What the BIS was saying is that the longer rates stay low, the higher debt levels become and the more vulnerable the financial system and the real economy becomes to an eventual rise in rates. When the accident happens rates will be back at zero and the printing presses will be up and running again. Yes bonds are expensive today, but betting on a significant rise in yields needs us to be sure that the three forces are working. The dynamics of inflation and the battle between macro policy and micro supply and demand are core to this.

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