Are we there yet? The search for global inflation
Post the Global Financial Crisis (“GFC”), precipitated by the collapse of Lehman Brothers in September 2008, the global bond markets set off on a road trip as globally the animal spirits and excesses that built up going into the GFC commenced the drawn out process of deflation. This process of deflation has unleashed two competing forces. On the one hand, the global deflation typically associated with an unwinding of the previous excesses within both the private and public sectors. On the other hand, the actions of central banks around the world which are undertaking highly accommodative policies in order to reflate the global economy and spur inflation. So there are two competing pressures acting on inflation namely global deflation pushing inflation down and central banks trying to push inflation up.
Which will prevail?
Ultimately, as with any centrally determined policy, it has by and large been taken for granted that central banks will ultimately succeed with respect to their reflationary policies simply because they can keep monetary policy highly accommodative until such time as they achieve the levels of economic reflation they are targeting. The complication is each economic cycle is different so the market participants can’t necessarily use history or past relationships as a guide. The dilemma for bond markets therefore has become not determining if inflation will pick up but rather when inflation will start to pick up.
Which brings us back to the question that financial markets have been asking for the last eight years “Are we there yet?” Or put another way, have the global economies reached that tipping point where reflationary policies from central banks will start to spur a pickup in global inflation? This is a question which the markets have been asking from the time the US Federal Reserve “pulled out of the garage” and started aggressively easing monetary policy in late 2008.
Complicating the search for an answer by investors in bonds has been the need to balance the impact on bonds from the ongoing downside pressures from global deflation, such as declining oil prices, with signs of reflation in parts of the world, namely the US. Overall, the forces of deflation have won out over the last 8 years as bond yields around the world have declined materially with Australian 10 year bonds declining from over 6.0% in 2008 to around 1.8% in August 2016. Further exacerbating the deflationary pressures on bond yields has been the distortion in the demand dynamic associated with central banks buying large quantities of bonds as part of quantitative easing policies thereby forcing certain institutional investors, such as insurance companies and banks which have no alternative due to regulatory requirements, to continue buying bonds even when yields are negative.
So have we reached that point when inflation will begin to pick-up?
Overall the evidence does suggest many of the deflationary headwinds facing bond markets over the last eight years, such as declining oil prices, are dissipating. This suggests that all else being equal, the accommodative policies put in place by central banks will start to bear fruit and assist inflation to rise. However not all else is equal. If there is one factor which has become clearer in the post 2008 period it is monetary policy is less effective at stoking inflation when underlying sentiment within economic systems is more subdued. For this reason, monetary policy can assist to offset deflation but is less likely to reignite materially higher levels of inflation in the current environment. Inflation is still likely to rise over the medium term but the odds favour any rise in inflation being more muted than the absolute level of monetary stimulus would suggest.
So the answer to the question as to whether “We are there yet?” is both Yes and No.
Yes, we have probably reached the point in the cycle where monetary policy is more likely to start having an impact on pushing up inflation. No, in that it is highly likely we still have some way to go in the journey before inflation is at risk of rising materially.
So how should an investor position given the potential risk of rising inflation? Overall Russell Investments views at this point in the cycle, investors should be increasingly wary of longer duration fixed income assets. This means for investors utilising the Russell Investment’s Fixed Income ETFs there should be a bias towards higher than “normal” exposures to shorter duration fixed income securities such as Russell’s Australian Select Corporate Bond ETF (“RCB”) and Russell’s Australian Semi-Government ETF (“RSM”). Conversely a modest bias away from the longer duration exposures such as Russell Government Bond ETF (“RGB”), which provides an exposure to longer duration government bonds, would also appear appropriate. In Russell Investments’ opinion, a material overweight to longer duration fixed income securities, such as contained in RGB, would only be justified if there was an expectation of the global economy tipping into recession. Such a recessionary scenario is not something which Russell Investments would currently view as a central case scenario.