The market often seems like a London commuter with an umbrella and a mobile phone: failing to look ahead and causing damage to bystanders by overreacting to near term threats.
But there has certainly not been any overreaction when it comes to potential inflation. The recent drone attacks on Arabian oil facilities prompted emotive headlines and some sharp moves in oil prices:
But the market was clearly not concerned about any sustained inflationary pressure. On the day of the spike, many government bond yields rallied, even in markets like Germany where even modest inflation represents a huge threat to negative yielding long term government bonds.
Why didn’t the move impact inflation expectations?
The reality is that, in spite of a record short term move, the impact on the oil price was relatively muted, even in the context of this year:
Our colleagues at The Equities Forum have discussed some reason why the oil price moves wasn’t more pronounced, including the important role played by inventories and the fact that a large part of production that was brought back online more quickly than expected.
However, the lack of market reaction on the day itself is a reflection of some much broader trends that have left most of the market very comfortable with inflation dynamics in the developed world. Today, shocks such as the oil price move last week seem less likely to impact inflation expectations than they may have done thirty years ago.
A number of reasons have been put forward to explain this shift:
- More open global trading relationships have meant that, for many goods, a shortfall in supply (or other upward price pressure) in one region can be more easily met by new supply from elsewhere, helping mute upward inflation pressure. In the case of oil itself, Scott Montgomery at the Jackson School of International Studies has illustrated the importance of US supply, which itself was arguably incentivised by high oil prices in the 2000s.
- Price increases in a single good like oil are now less likely to translate automatically to higher wages across the whole economy. Though politically a charged topic, it does seem that a decline in unionisation, wage indexation, economy-wide reliance on single sectors, and the effective increase in the supply of labour via ‘gig economies’ and ‘offshoring’ have reduced the propensity for persistent ‘wage-price spirals.’
- More diversified, service-driven economies (particularly in the West) mean that single inputs (particularly commodities like oil) have a less dominant role in the pricing elsewhere.
- Greater price transparency provided by the internet may mean that firms may have less ability to pass cost increases on to customers (even as ‘winner take all’ dynamics suggest a lack of competition).
- The role of improved technology means that the prices of many goods have fallen dramatically, and in many cases are effectively free (think postal services, access to news and media). In the US, one can partly illustrate these impacts by observing the decline in price on many goods, in contrast to the types of goods and services which have appreciated.
These trends seem to have played a large role in ensuring that the general price level in many parts of the world has remained predictable, stable, and low, and often surprisingly so, given the loud calls by many that ‘money printing’ after the financial crisis, or a doubling of the oil price (in 2004/5 and again in 2007/8), would prompt rampant inflation.
While we should be wary of fitting such simplistic narratives to major trends, the chart below shows how anchored global inflation has been since the mid-1990s. It also suggests that the sensitivity of global inflation to oil price moves is much diminished from that of the 1970s and 80s:
The chart above is also in keeping with work from Fed Governor Frederic Mishkin in 2007 that identified both a decrease in inflation persistence and sensitivity to shocks. This in turn was echoed in a piece from the Federal Reserve Bank of San Francisco earlier this year.
Should the market be looking further ahead?
It therefore seems appropriate that the market was muted in its response to last week’s Saudi attacks. However, could it be that the market is failing to look ahead to potential threats to those very structural forces which (may) lie behind the decades of stable inflation that many of us have enjoyed?
There are certainly some areas that have been highlighted as cause for concern:
Tariffs and the threat to globalisation
Economists seem to be broadly in agreement that tariffs have damaging effects (though the strength of arguments today could reflect emotional forces). A key part of the argument against them is that domestic consumers typically bear the costs and are therefore inflationary. The IMF found evidence for this in a piece earlier this year as did a piece on protectionism from 2018. In the UK, others have made similar arguments with regards to the potential impacts of Brexit.
And yet, while asset prices have (correctly) reflected concerns over the impacts of trade wars on growth, there is little sign that inflation is as large a concern.
Tight labour markets and wages
Similarly, while policy makers and others have debated why it is that low levels of unemployment in parts of the developed world have not prompted wage inflation as traditional theory would suggest, markets seem to have lost faith in the relationship between employment and inflation some time ago. In the US, the recent bond rally has come against a background of robust real growth in hourly earnings:
Again, this is an issue that can become politically charged (this article from the former senior statistician at the Office for National Statistics outlines some of the common myths about job data in the UK), and cross country comparisons are difficult. What is useful for investors though is trying to understand which issues the market chooses to worry about and which to ignore at various points in time, and why this may be.
Government spending and policy shifts
One of the biggest surprises in the last month were suggestions that even Germany could be considering more government spending (alongside the recently announced spending on climate goals). Many will be sceptical about the genuine prospects for this but the suggestions themselves are indicative of an environment in which fiscal tools are being given greater credence by economists and policy makers (consider recent rhetoric in the UK).
Alongside this, a range of new policy proposals are becoming more mainstream around the world; in the summer Bond Vigilantes interviewed the author of ‘The People’s Quantitative Easing’, and our own Eric Lonergan has been actively involved in discussing possibilities for new approaches to policy. The rise in attention to MMT and green new deals further illustrate a growing focus on government roles in managing economies. As we have argued before, these types of political development are often more important that the twists and turns that grab the headlines.
Tech Regulation and taxation
It is questionable whether the monopoly power of large tech companies has resulted in higher prices: it can be hard for companies to maintain a moat in an environment where price discovery is easy and potential competitors have lower start-up costs and significant scalability. However, potential new regulatory and tax burdens on incumbents could make it harder for competitors to present a credible threat by raising the cost of doing business.
Right thing, wrong reasons?
For those that hold to the episode investment philosophy, all the issues above would fall in the category of things to be aware of and follow, but not to try to forecast. It is arguably far better to focus on prevailing valuations and signs of excess volatility, and to be as agnostic as possible at the path that economic fundamentals will take.
On inflation, the market certainly appears to be agnostic today. The reality for the working lives of many participants is that, with specific exceptions, inflation has not been something that they have needed to worry about and few are willing to bet on that changing.
However, it is often the case that for long term trends such as the possible developments above, the market will vacillate between worrying too much and being too complacent, depending on what is going on in the shorter term.
Such inconsistent responses to developments can help provide a sense of whether asset valuations are reflecting considered views of fundamentals or more temporary behavioural forces. In the case of bonds: have markets apparently ignored potential inflationary threats because they are genuinely thinking long term or might there be signs of bubble-like behaviour? The Saudi oil attacks are unlikely to give us much of a steer on this, given the limited fundamental impact, but if last week’s price moves are indicative of one in which already low yielding bonds rally into potentially inflationary conditions, this can be an important heads up for investors that fundamentals are being ignored.