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Lower for longer The impact of sluggish inflation on expected returns
April 2016
UBS Asset Management,
Investment Solutions Team
By Michele Gambera, PhD, CFA Head of Quantitative Analysis, Investment Solutions
2
In our recent paper, Your guide in a low yield environment, we looked at
the challenges facing investors in an environment of low inflation, low
interest rates, low yields and low returns. In this paper, we review the
underlying factors that have suppressed inflation in the recent past, look
at the latest macroeconomic data for pointers to the likely trajectory of
inflation in the near future, and suggest some effective tactical solutions
for investors.
Lower for Longer: The impact of sluggish inflation on expected returns
3
Lower for Longer: The impact of sluggish inflation on expected returns
Only a few years ago, economists warned of the potential for
rising inflation, triggered by central bank quantitative easing
policies following the 2008 financial crisis, citing economist
Milton Friedman’s warnings about the inflationary effects of
printing money.
But that didn’t happen; instead, in much of the developed
world, inflation is running well behind historical norms, with
negative interest rates in a handful of countries. Core inflation is
currently 1% in the Eurozone and 0.8% in Japan. In March, the
Federal Reserve Bank of Cleveland reported that its latest
estimate of 10-year expected inflation is 1.65%, or less than
2% on average over the next decade.1
Friedman would have attributed this low inflation to a declining
velocity of money, or the number of times per year a dollar turns
over to buy goods and services. In response, central banks have
increased quantitative easing programs and maintained low
interest rates, and some have begun adopting negative deposit
interest rates in recent years—charging banks for holding their
money. Earlier this year, the Bank of Japan was the latest to
follow this trend.
In contrast, the US Federal Reserve raised its key interest rate in
December to a range of 0.25% to 0.50%, after more than nine
years at 0%. Fed Chair Janet Yellen said in March that global
economic uncertainty calls for a slow pace of increases, so the
Fed rate is unlikely to go much higher soon.
Low inflation adds to investor challenges
The zero and negative nominal interest rates introduced by
central banks in Japan and Europe, including in Switzerland and
in various Scandinavian countries, are designed to stimulate the
economy. The interest rate that drives capital investment
decisions is the ‘real’ interest rate, which is the nominal rate
minus the rate of inflation. Central banks have historically
brought their reference (nominal) rates below inflation to
stimulate the economy with negative real rates.
We believe that central banks around the world will continue
efforts to increase inflation to their 2% target over the next few
years, with varying degrees of success. While we expect inflation
to rise modestly in the US and the Eurozone over the next year,
new challenges could arise if persistently low inflation leads to
additional and unexpected central bank actions.
Given the limited ability for companies to expand profitability in
a low-inflation environment, equity returns may be modest, and
there are implications for fixed income and commodities as well.
Inflation reflects companies’ pricing power—lower customer
demand removes pricing power and impedes top-line growth.
At the same time, costs are either flat or rising slightly, which
can squeeze margins. The only route to maintaining margins in
this scenario is for companies to cut costs, which has limits of its
own. Bonds look more attractive in this environment, from a
price appreciation standpoint as opposed to an income
standpoint, unless surprise inflation spikes or rate increases
show up to spoil the bondholders’ party.
Therefore, in order to meet risk/return objectives, the balance
between return generation from market exposure (beta), skill
(alpha) and other factors may need to be altered.
1 The Cleveland Federal Reserve Bank’s estimate of inflation expectations is based on a model that combines information from a number of sources to address the shortcomings of other commonly used measures, such as the “breakeven” rate derived from Treasury inflation protected securities (TIPS) or survey-based estimates.
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Lower for Longer: The impact of sluggish inflation on expected returns
The impact of global demand and capital expenditure
on inflation
Inflation is being constrained in much of the world by a ‘perfect
storm’ of negative factors. Global demand has been weak as
developed markets continue to recover from the great recession.
At the same time, negative demographic trends, private
deleveraging, and years of fiscal austerity, especially
concentrated in infrastructure investment, have significantly
dampened potential growth in many major economies.
Note, in Exhibit 1, how real GDP in the industrialized countries
after the mid-1990s has been growing more slowly than in the
1960s. Investment levels have also dropped over the same time
period. It is unclear which is cause and which is effect, or whether
these two variables are jointly determined.
Governments cut infrastructure expenditure because delaying
bridge maintenance, for example, is politically easier than laying
off workers. In the private sector, companies have cut equipment
investment and research and development because they
currently do not expect demand to grow, nor do they see
adequate return potential on those investments even with the
cost of capital at historic lows. At the aggregate level, this
reluctance to invest has been ongoing for years and has
contributed to slower economic growth.
Weak commodity prices hurt emerging market economies
Emerging markets that are commodity exporters have felt
pressure from falling commodities prices. Three factors have
combined to hold down the prices of gas and oil in particular in
recent years:
• Demand: In addition to a long-term trend toward higher
energy efficiency, the current global economic climate has
resulted in weak demand for commodities (not limited
to energy).
• Supply: New oil and gas extraction technologies have
improved efficiency and can respond more quickly to price
change. Several countries obtain the majority of their
Exhibit 1: Capital expenditure has trended lower in the last five years in OECD countries
Source: Thomson Reuters Datastream/UBS Asset Management.
Gross fixed capital formation (Real, % year-over-year): OECD total
GDP (Real, % year-over-year): OECD total
-15
-10
-5
0
5
10
15
20
‘65 ‘70 ‘75 ‘80 ‘85 ‘90 ‘95 ‘00 ‘05 ‘10 ‘15
-4
-3
-2
-1
0
1
2
3
4
5
6
7
8
‘65 ‘70 ‘75 ‘80 ‘85 ‘90 ‘95 ‘00 ‘05 ‘10 ‘15
5
Lower for Longer: The impact of sluggish inflation on expected returns
government’s revenues from oil sales and royalties, and
because their costs are in (devalued) local currencies while
revenue is in dollars, they have a strong incentive to keep
producing; the new supply created by oil shale technology
is ready to come back online if oil prices rise too much.
• The dollar: A strong dollar means that commodity prices,
which are typically denominated in USD, will tend to
decrease.
Some economists suggest that dollar-denominated borrowing
has choked several emerging markets since the strengthening
of the USD, beginning in 2014. While the dollar was cheap,
companies outside of the US borrowed in dollars, which was
cheaper than borrowing in their own currency. Now that the
dollar has strengthened, interest in borrowing has waned, but
the burden of repayment has increased.2 The continued strong
dollar will further hamper economic growth as financing has
become less accessible and more costly.
The China price
Furthermore, countries that export finished goods to
industrialized countries have not thrived, despite the advantage
of being able to acquire primary inputs such as commodities and
labor at lower prices. Their problem is that demand for finished
goods, particularly from the developed world, has been lagging.
In the past, the “China price” was used in international supply
chains to decide where to produce goods. This created
competitive pressure that globally kept inflation relatively low
at the beginning of this century.
Where there is price competition, sellers can’t raise prices to
improve their profit margins; it is reasonable to expect that
import prices will continue to provide a ceiling to pricing power.
Sellers cannot increase prices if demand is weak, and therefore
pricing power is diminished, until and unless global growth
increases to the point of overheating product markets.
In its hope to avoid the pitfalls learned from export-led growth in
Japan, China has been trying to steer the focus of its economy
away from exports and toward the internal market—a move that
should pay off, but only over time. In the meantime, this shift is
adding to the softening of global demand.
Moreover, services in poorer countries are often provided within
a family and without market transactions, thus increasing the
market weight of necessities. In richer countries, where shelter,
health care and services are a bigger part of spending, inflation is
likely to grow more rapidly.
In the examples shown in Exhbit 2, Germany has a CPI basket
weighting to food of 10.3%, compared to 18.2% in South
Africa. Similarly, Germans spend more for housing than South
Africans, at 21.8% versus 16.6%.3
Similar differences in commodities-based versus nontradable
goods and services exist between developed and developing
countries globally. In markets where citizens spend a larger
proportion of their income on commodities, including energy,
rising or falling commodities prices will tend to have a bigger
impact on overall inflation rates.
Exhibit 2: Consumer Price Index (CPI) baskets differ across the world, reflecting income levels and special circumstances
USA
0%
5%
10%
15%
20%
25%
30%
35%
Food Energy Housing Services Other
Germany South Africa
2 http://www.economist.com/news/finance-and-economics/21693961-why-borrowing-dollars-central-business-cycle-developing
3 All data are from http://stats.oecd.org/.
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Lower for Longer: The impact of sluggish inflation on expected returns
Exhibit 3: Japan a mixed bag, trending down in the short term
Exhibit 4: Eurozone–the deflation risk is real
Exhibit 5: US inflation measures are moving towards the normal range – Fed will tighten further
CPI Core (6)
PPI Fin (6)
PPI-Inter (6)
Frcst Output Prcs (2)
Frcst Input Prcs (2)
Lab. Pdy (0)
ULC Total (-3)PPI - Input (-6)
Oil Price (-6)Import Prices(-6) M
ar ‘08
Sep ‘08
Mar ‘09
Sep ‘09
Mar ‘10
Sep ‘10
Mar ‘11
Sep ‘11
Mar ‘12
Sep ‘12
Mar ‘13
Sep ‘13
Mar ‘14
Sep ‘14
Mar ‘15
Sep ‘15
Mar ‘16
Mar ‘08
Sep ‘08
Mar ‘09
Sep ‘09
Mar ‘10
Sep ‘10
Mar ‘11
Sep ‘11
Mar ‘12
Sep ‘12
Mar ‘13
Sep ‘13
Mar ‘14
Sep ‘14
Mar ‘15
Sep ‘15
Mar ‘16
Mar ‘08
Sep ‘08
Mar ‘09
Sep ‘09
Mar ‘10
Sep ‘10
Mar ‘11
Sep ‘11
Mar ‘12
Sep ‘12
Mar ‘13
Sep ‘13
Mar ‘14
Sep ‘14
Mar ‘15
Sep ‘15
Mar ‘16
Price Expec (5)Lab Cost (4)Price Expec (Retail) (2)Price Expec (Services) (2)Oil Prices (2)
Core PPI (1)
Imp Prices (1)
PPI (0)
Cnsmr Price Svy (0)Mnftn Prices (0)
Inflation Frcst This Yr (-2)Inflation Frcst Next Yr (-2)
M3 (-4)CPI - Core (-6)ULC (-6)
ULC (6)ISM (3)Philly Paid 6m (2)Philly Paid (2)Philly Rcvd 6m (2)Philly Rcvd (2)ISM Non-Mfct (1)NFIB Expected (1)PPI Fin. (4)
Import Prices (0)NFIB Current (0)PPI Interm. (0)Mich 1 yPPI Raw (0)Oil Price (0)CB 6mTrimmed Mean (-2)Median CPI (-6)Core CPI (-6)
Standard deviations from the average
Bands are 0.2 standard deviations wide with neutral between -0.1 and 0.1
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Lower for Longer: The impact of sluggish inflation on expected returns
Indicators for inflation in the near term
We have studied a number of macroeconomic variables and
have found that historically some of them have been reliable
predictors of inflation. The charts on page 16 help to put
inflation expectations in the context of these leading inflation
indicators (see Exhibits 3, 4 and 5).
In the following ‘heat maps,’ each row represents the most
recent price change information for a key inflation indicator,
relative to historical trends. Shades of green show above-trend
activity, while shades of blue signal below-trend performance.
The indicators are listed in the order of how many months they
lead or lag actual inflation, with the number in parenthesis
indicating the number of months. The height of each row
corresponds to that indicator’s correlation with inflation
rates, relative to other indicators.
The key differences between the heat maps for the US, the
Eurozone and Japan are the dynamics of the leading indicators
(the top rows of each chart). While the US has some green
indicating that inflation measures are converging toward the
Fed’s target of 2%, Europe shows a deep blue indicating that
inflation is converging to zero or perhaps to a negative number,
which is a material cause of concern since a negative price trend
leads people to delay big purchases, hoping for even lower
prices and therefore depressing aggregate demand in the short
term. Japan’s indicators show a confusing mix, while we wait for
recent monetary easing to bear fruit.
By way of example, in the US heat map, a key indicator is in the
top row, Unit Labor Costs (ULC), which has trended into positive
territory for most of the past year. Rising costs associated with
labor are historically a reliable inflation indicator. The Eurozone
heat map offers virtually no comparable indications of rising
prices.
These heat maps help explain why the US Federal Reserve
decided to begin raising interest rates in 2015, while central
bankers in Japan and the Eurozone have turned to negative
interest rates in recent months.
Low oil prices will exert progressively less drag on year-over-year
headline rates of consumer price inflation in 2016, as shown in
Figure 6. A modest rise in inflation would be welcome, helping
to reduce the threat of deflation in places like Japan. But what
will matter most to asset prices are central banks’ responses.
Overall, we believe that inflation will probably move higher
gradually. It will largely be driven by energy prices, and thus
represents little cause for alarm as commodity prices are unlikely
to reach the highs of 10 years ago.
Inflation has consequences
Inflation is just one macro-variable, and we are watching many
more. However, we believe that inflation will be a key macro-
variable that sets the tone of asset returns for the next three
to five years. The intermediate-term return environment is
characterized by the potential for a more volatile business cycle
and for low expected returns for equities due to narrow margins.
Inflation normalization may encourage central banks to
normalize rates, which will result in higher bond yields, which
reduces the total returns of bonds via the duration mechanism.
As a consequence, beta alone—pure passive exposure to asset
classes—appears unlikely to meet return requirements for many
investors. After a protracted period during which beta has
dominated returns, this shift is a significant one. Against this
backdrop, fund manager skill is likely to play a much greater role
in investment returns, and a return to active management should
be considered. This may be a propitious time to introduce a
top-down tactical asset allocation plan.
Elements of an investment plan should include:
• Lowered return expectations due to increasing
interest rates
• An allocation to illiquid assets to capture the liquidity
premium (if the investor has a long enough horizon)
• A risk allocation approach to think not just in terms of
expected returns, but of risk-adjusted expectations
• A plan to take advantage of the cyclicality of markets
by applying top-down active management and global
tactical allocation
Exhibit 6: Stabilizing oil prices are forecast to bring modest
inflation to the US and the Eurozone in 2016
Change in oil price year-over-year, assuming forward pricing, in %
Jan ‘11-60
-40
-20
0
20
40
60
Jan ‘12 Jan ‘13 Jan ‘14 Jan ‘15 Jan ‘16 Jan ‘17 Jan ‘18
Source: Bloomberg Finance LP, UBS Asset Management. Data as of April 2016.
Source, Page 16: Institute of Supply Management, Federal Reserve, PMAC, University of Michigan, Conference Board, Bureau of the Census. Data as at 07 April 2016.
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