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Sultans of Swing



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(Photo: NN Investment Partners)

Yet another disappointing inflation report. Many had been looking forward to last week’s report on US consumer price inflation and hoped to find confirmation that price pressures were finally rebounding. After a soft patch in global inflation trends in the first half of the year, the Summer period brought back some life to inflation dynamics. As economic growth remained healthy and, in recent weeks, also positive surprises on economic data moved upwards again, the reflation-theme revived somewhat in global markets.

Bond yields rose again, inflation expectations moved up somewhat and cyclical equities where star-performers again. At least, until signs emerged that the upward momentum in inflation might be stalling yet again.

Rather than debating that the future of market behaviour lies on the reflation or the yield-searching theme, the sensitivity of market behaviour to very short-term inflation dynamics underscores what a swing factor for markets the inflation outlook has become. Given the importance of nominal income trends in overcoming the global debt burden, the extent to which corporate earnings can continue to grow firmly and the degree to which central bankers can normalize their policy stance, it is well understandable that markets reshape substantially as inflation odds evolve. In this respect, it is also understandable that markets re-assess their belief about the reflation-trade in the early part of this year.

The graph below shows clearly that underlying inflation momentum in the Japan, Europe and especially the US shifted down early this year, only to rebound towards the Summer period.

 

 

Part of the high market sensitivity is also stemming from the higher uncertainty over the outlook for inflation. Without the assumption of gravitational forces bending inflation back towards an “objective” equilibrium or a central bank’s target, the current pulse in inflation becomes a patch that is more likely to persist for longer. Shorter-term trends thereby get a bigger weight in the expectations that build in investor’s minds as future inflation scenarios are less anchored by model outcomes. And market prices are nothing else than the collective imagination of all of us: investors that aim to win a massive forecasting competition. And to win in the current uncertain environment, a faster understanding of the future path of inflation is a furious weapon.      

Next to inflation, the direction that productivity growth will take is probably the most important swing factor for markets. The nominal side of the economy is crucially important to help rebalancing and stabilizing our economic system (and supporting nominal asset prices!), but the real and sustainable gains in prosperity are driven by productivity improvements. It is thereby also what influences the level that central bank rates can reach, the pace that profits can grow and the extent to which final demand can expand on a durable basis. That all matters a lot to markets. 

And to complicate matters for markets, they are at least as much in the dark on the future of productivity growth as they are on inflation. And if both economists and investors are honest about it, it’s probably not even a new sense of oblivion. Basically, we have a pretty good understanding of the factors that influence productivity, like technological innovation, capital deepening, human organisation around and application of technology and the enthusiasm of consumers and firms to embrace new products and services. We have very little understanding however of the complex interactions between all these forces and in which way they eventually translate into observable productivity gains. 

Currently we are again living in an age full of much discussed and very visible technological change. The digital revolution has changed both our private and professional life styles and the talk about robotics, A.I. and machine learning is everywhere. But yet again, not in the productivity numbers.

The graph below shows very clearly how productivity growth has slowed to multi decade lows over the last 10 years. And although the graph is about the US economy, this is observed in almost all developed market economies.

 

 

And maybe similarly to inflation, some rays of light have become visible over the last year, but the future direction remains highly uncertain. Therefore even an open-minded and humble interpreter of economic data points will remember that using the latest available information, even if limited in size, to update and tilt one’s opinion about the most likely future scenarios is actually an agile and robust way to sharpen decision making under uncertainty.

The music that will be played in the market might therefore well be composed over the coming period by these two Sultans of Swing: inflation and productivity. Politics and policy makers will play their part to add some background vocals to the noise, but getting it right on either inflation or productivity will be needed to make it to the investor charts. Beating the drum on both will make you win close to eternal peer and client respect. And maybe even betting, it might just feel like Money for Nothing.

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