The Silver Bullet | When Inflation Dreams Become Nightmares

Since the start of quantitative easing, bringing inflation back to normal has been a sacred grail for central bankers. A banking system on its knees, falling money velocity, lack of fiscal stimulus to accompany monetary policy and the structural drivers of secular stagnation – lower demographics and deflationary technology – all made the task look unachievable.

But we believe the tide is turning in 2017 – not only for the United States, which has long benefited from a quicker recovery, thanks to more flexible capital markets and less reliance on banks. Inflation is making a comeback in Europe too, and this will mean trouble for the European Central Bank and the Bank of England.

What are the game changers?

1. Trumponomics means more inflation. As we anticipated before US elections, a Trump victory would mean more spending, a larger deficit and rising inflation. Even though Congress may only pass a fraction of the infrastructure spending proposed during the campaign, a reduction in corporate taxes as well as the introduction of a border tax on imported goods are likely. Together, these measures are likely to increase inflation substantially, up to one percentage point higher than current levels.

2. A hawkish Fed Chair and a weaker Euro. A new Fed Chair will likely take a more hawkish tone than Yellen. Even though many FOMC members remain accommodative, including Vice-Chairman Fischer and President Dudley, the balance could shift towards faster hikes and/or a reduction in reinvestment of interest under the QE programme.
Together, faster growth and inflation in the US could mean the Dollar will appreciate – albeit the Trump administration may well try to prevent suddent increases. In turn, this creates a better environment for European exports. However, the benefit won’t be shared equally across Europe: some countries will gain more than others, as the table below shows.

Import vs export inflation: Germany, already at 1.7% inflation at the end of last year, is the most sensitive exporter to a weaker Euro. A simple analysis shows that every 10% depreciation in the Euro could boost German GDP by 0.14pp and inflation by 0.06pp (based on sensitivity of current account surplus to EURUSD). In the UK instead, inflation is likely to be import-led, caused by a weaker pound and rising cost of imports. Wages and growth are likely to stagnate, given the likelihood of a hard Brexit, and the lack of realistic negotiation expectations or an economic plan to deal with the economic aftermath (See WSJ | Markets to May: Britain needs a better Brexit Plan and The Silver Bullet | The High Price of a Hard Brexit).

3. Banks are back. Besides the ‘pull’ effect from the US economy, Eurozone countries will also benefit from a more solid banking system, finally able to transmit monetary stimulus to the real economy. Unlike in the US, where capital markets represent four fifths of credit supply and a faster bankruptcy framework allowed for an efficient absorption of losses during the crisis, the Eurozone as well as the UK remain tied to financial institutions. Banks are key to growth particularly in Southern Europe, where loans represent up to 90% of credit and small businesses create over 80% of new jobs, according to EBA data.

Since 2010, Eurozone banks have added over €260bn of capital, bringing their capital ratios above 13% from less than 7% on average (EBA). More importantly, the size of Europe’s banking system has shrunk and quality of balance sheets improved, as banks reduced lending and optimised balance sheets. In the Eurozone, banks are now below 300% of GDP from 340% pre-crisis; in the UK they have fallen to around 360% from 430% pre-crisis.

The combination of stronger balance sheets, a peak in regulatory adversity and legal fines as well as a better outlook for profits, with steeper yield curves engineered by the ECB and BoJ, all mean banks are more eager to lend. Further actions to reduce the stock of Eurozone non-performing loans, currently at €1tn or 10% of GDP, and to consolidate the system would further unclog lending and reduce the differential between core and periphery countries.

 

4. Stimulus replaces austerity. After many failed experiments – Greece for a start – European policymakers could finally come together to provide some stimulus. The ball is clearly in Germany’s court, the country which accumulated the highest surplus as the union made its currency much lower than it would be otherwise. While we are unlikely to see a coordinated pan-EU plan for spending, a more expansionary fiscal budget is possible post German elections, focusing on defence spending in light of the upcoming UK’s departure from the EU and reduced support for NATO from the Trump administration, as well as for the 1mn refugees the country accepted. In addition, more flexibility will also likely be granted to other countries against EU budget rules.

5. Europopulism is on the rise. If Trumponomics is inflationary, European populism will be, too. In the UK, the impact is already clear, with 10-year inflation expectations around 3.6% after Brexit. In the Eurozone, a potential victory of protest votes in the Netherlands or France would increase uncertainty and risk premia but would also probably result in higher wages and protectionist measures on migration – both supportive of inflation.

6. Oil prices have upside. At the end of 2016, OPEC and non-OPEC members made a historic deal to cut almost 1.75m barrels of production or roughly 1.8% of total global supply. This reduction may appear small, but it will likely help stabilise the oversupply in the oil market. In its latest monthly report, OPEC estimates that average monthly oversupply in 2017 would fall to 985k bpd vs a previous estimate of 1.24m bpd. A reduction in supply as well as continued adherence to agreed cuts could continue to support oil prices. Consensus estimates are for oil prices in 2017 to rise to $56.3 by December, which is almost a 5% YoY increase (WSJ). Such an increase would have a significant positive base-effect impact on year end inflation estimates; with oil weighing 3.5% in the German CPI basket and 2.85% in the EU CPI basket, a 5% YoY increase in oil prices would mean almost a 17bp and 14bp boost to YE German and EU CPI, respectively.

 

Hey Mr Central Banker, Be Careful What You Wish for

If the ECB so far was able to implement non-standard monetary policy in the name of its inflation mandate, we believe it will be harder for them to justify a prolonged extension of QE, with inflation closing in around 2% in Germany. The key issue to solve for Mr Draghi and his team, at that point, will be to close the inflation/credit spread gap between core countries (Germany, Belgium, Austria, Finland) and periphery countries who have reformed (Spain), which are now seeing a return of investment and inflation, against the laggards (France, Italy, Portugal). Reducing this structural gap entails working on banking systems and national reofrms – a much more challenging task than QE.

What are the policy tools available?

To reduce the differential in spread and inflation across countries, the ECB could foster the cleanup of non-performing loans in the periphery and for the creation of alternatives to bank lending. Both are long term solutions, however, and only implementable with the aid of national governments.

The most likely scenario this and next year will be that the core-periphery differentials will persist or widen. With inflation nearing 2% in Germany, justifying quantitative easing – let alone a deviation from the capital key – will become much more difficult.

In the UK, the Bank of England has even less flexibility: despite a likely surge in inflation, it is hard for the BoE to tighten rates. First, a low-growth environment post-Brexit will warrant continued monetary easing. Second, higher rates will make overlevered British households even more financially vulnerable. The Office for Budget Responsibility projects household debt to continue rising, reaching 148% of household disposable income by the start of 2021. In short, the BoE is likely to have no choice but to tolerate higher inflation, potentially letting inflation go over 4% in 10-year swaps.

Conclusions:

The comeback of inflation might be good news for borrowers but will spell trouble for bondholders – especially in Europe, where government bond yields offer much less than inflation. Despite a strong start to the year, we believe 2017 will be a difficult investment environment. Volatility is likely to rise, with Dutch, French and German elections in Europe, Brexit negotiations and the probability of a trade clash between the Trump US administration and China. Against this backdrop, fixed income investors appear to be long duration as much as ever, as the IMF warned.

In our macro strategy, we are wary of these risks and prepared to navigate such an environment. We remain long default risk in credit, but maintain a negative positioning on duration and have reduced exposure to spreads adding convex hedges since the start of the month. Alfred Hitchcock used to say a film should be worth the cost of its ticket, dinner out and a babysitter watching the kids. If the same was true for active funds, then 2017 may finally be the year when the ticket could be worth its price.