The return of inflation 'volatility'?

The more markets rely on something that has not yet appeared never appearing, the greater the impact if it does…

A period of synchronised global growth is challenging the consensus narrative that inflation ‘volatility’ is dead

Market pricing of both inflation and expected central bank policy moves does not reveal much apparent concern around this threat. However, the largest one day rise in equity volatility in February would suggest otherwise.

In 2018 so far, equities have rallied and high yield bond spreads have tightened during weeks in which market expectations of future inflation have increased. This is the same dynamic as that seen in the last three years and more broadly since the financial crisis. So far, higher inflation has been a 'risk on' phenomenon. Instead, it is when inflation expectations have been falling that markets have been on the back foot. However, that could all change in the second half of the year…

Inflation expectations in both the US and other developed economies will be key from here. Signs of price pressures increasing more broadly would likely make for a much more challenging environment as the year progresses. Markets have priced a very limited move higher in inflation or normalisation of policy outside the US. This could in turn lead to some surprising shifts by central banks, who let’s not forget, have been a very supportive factor in markets since the financial crisis. The backdrop to all of this is that global central bank balance sheets will likely peak in the third quarter of this year.

Geopolitical threats, especially around trade tariffs, could further amplify the issue. With the US labour market so tight, any decision to effectively pull up its borders and source domestically will concern markets about the potential inflationary impact. The risk to company margins won’t be lost on equity investors either. Oil prices sit almost 40% above last year’s levels and are already having a pass through effect on inflation. We watched with interest the recent release of higher than expected inflation readings in the majority of Eurozone countries – while energy was a factor, further analysis revealed that the upside surprise was delivered more from services than from higher energy prices.

The demographic and long-term saving challenges the world faces have always given us confidence in the view that the world has a constant need to buy long-duration assets (and therefore at any given time is ‘short duration’ relative to how they will need to be invested). What was revealed in early February is that markets are also ‘short volatility’. These are two very powerful forces and it will be their interaction that will determine investment returns this year.