Outlooks 2017

What next for inflation?

We explain why inflation is on the rise and look at the situation in the US, UK, Europe and China

23/02/2017

Ben Arnold

Ben Arnold

Investment Writer

Schroders

Inflation is waking up

Most of the major central banks are predicting rises in inflation. Price pressure was already beginning to build in 2016 as the world economy showed signs of improvement. Now the policies of a new Trump         administration – lower taxes and increased government spending – could increase that pressure.

The expectation among economists in January was for G20 inflation to rise from 1.09% in 2016 to 1.8% in 2017, with more marked increases in Western economies, according to OECD data.

Inflation in the UK will rise from 0.7% in 2016 to 2.9% for 2017 before easing back to 1.9% in 2018, according to Schroders forecasts. In the US, an increase from 0.1% to 2.3% is expected over that period.

Below we set out the inflation situation globally and for some of the largest economies, offering views from economists and fund managers. First, we explain the corrosive nature of inflation.

Why is inflation so important for investors?

Inflation erodes the value of savings over time. The higher the level of inflation, the faster the spending power of savings will fall.

The chart below shows how the real value of money effectively shrinks over 20 years, offering scenarios of 1% and 5%. After 10 years of 5% inflation, £100 has shrunk to around £60. Even with a low rate of 1%, the real value would fall to £90.

This underlines why investors strive so hard to achieve a return greater than the level of inflation – the “real return” that actually helps a portfolio to grow.

If inflation rises, investors are more inclined to move away from cash deposits and toward certain investments that, historically, have offered returns that outpace inflation. A repeat of this success is not guaranteed.

Where are we at today?

Inflation has been exceptionally low in developed world economies since the financial crisis of 2008-09. Some countries have even endured bouts of deflation. This was despite unconventional intervention by central banks with the electronic creation of money through quantitative easing (QE), aimed at kick-starting economies.

In the past few months, inflation has picked up significantly, as shown by the blue line in the chart below. Headline inflation rates are calculated using the consumer prices index (CPI). This index includes energy prices, such as petrol and heating oil.

Stripping out volatile energy and food prices adds a different perspective. This “core inflation” has been more stable (the orange line) and has not, so far, felt the knock-on effects of recent rising energy prices.

The art for economists in forecasting inflation is to judge the supply and demand balances in the economy. They look at the health of the jobs market and wage growth and at the price of goods leaving factory gates, which can offer early warnings of rising inflation.

It is also taken into account that the fear of inflation itself can stoke inflationary pressures, as workers see prices rising and demand higher wages. Surveys that show inflation expectations are closely watched.

US

2016 actual (Datastream): 1.3%
2017 Schroders forecast: 2.6%
2018 Schroders forecast: 2.3%
2018 Consensus forecast: 2.3%

US inflation has been on the rise since the summer after hitting a low of 0.8% in July. It passed the Federal Reserve’s 2% target and reached 2.1% in December.

It is not totally uncharted territory in the post-crisis years, having reached a similar level in mid-2014 and going higher in 2011. Rising energy prices have pushed the rate higher, particularly gasoline costs. Food prices, in contrast, have been falling.

The Federal Reserve has raised rates twice since December 2015 - a mechanism used to regulate the economy and control inflation.

Donald Trump’s presidential campaign was built on helping the American worker. Adding 25 million jobs was an immensely popular pledge, together with a promise to rip up trade agreements, such as the TransPacific Partnership.

Keith Wade, Chief Economist at Schroders, said: “Trade protection effectively limits the available supply of goods to a market, thus increasing upward price pressure. The same can be said of measures to prevent companies from trying to reduce costs by relocating abroad. Inflation remains the most likely outcome of the new president’s economic policies.”

The creation of 25 million jobs, if achievable, would clearly drive up wages and inflation given that only eight million workers are unemployed, Wade has noted.

He added: “All of this is moving in one direction and setting up a clash between the administration and the Federal Reserve. I am much more concerned about inflation under Donald Trump.”

Stagflation - high inflation combined with economic stagnation and high unemployment – remains a threat. The US went through a period of stagflation in the 1970s when the price of oil soared.

UK

2016 actual (Datastream): 0.7%
2017 Schroders forecast: 2.9%
2018 Schroders forecast: 2.2%
2018 Consensus forecast: 2.7%

The UK has its own particular inflation issues. The CPI index fell below 2% at the start of 2014 and eventually hit a low of -0.1% in September 2015. It began rising slowly after that and then more rapidly following the “Brexit” decision. CPI, at 0.5% in June, reached 1.8% by December.

A rise in global energy prices was largely the reason but a fall in the pound after Brexit also played a part. The reduced buying power increased the cost of imported goods, which make up 25% of all goods bought.

While the rising price of the famously British food spread Marmite caught the most interest domestically, many price rises have yet to filter through. Foreign car makers, for instance, have warned of higher prices ahead for British buyers.

Low inflation had begun to help the economy by boosting spending. The opposite may be true in the years ahead as currency-related price rises begin to be felt.

Wade said: “UK inflation is set to rise sharply due to the fall in the pound, which will reduce disposable income of households and encourage cuts in spending.”

Eurozone

2016 actual (Datastream): 0.2%
2017 Schroders forecast: 1.6%
2018 Schroders forecast: 0.9%
2018 Consensus forecast: 1.4%

The pattern of inflation in Europe has been similar to the UK. In the eurozone, the inflation rate has risen from 0.2% last August to 1.8% in January.

As with the US and the UK, rising energy prices are largely behind the bounce back. Energy inflation in the eurozone in the year to January was at 8.1%, up from 2.6% the month before.

Europe faces a year of major elections and uncertainty around the conditions of the UK’s departure from the European Union. This may have ramifications for economic growth which might affect inflation.

The table below outlines the major events of the year. In each, the Schroders Economics Group offers an opinion on the probability of it occurring and the market impact.

Schroders expects inflation to be lower in Europe than the UK or US.

Wade said: “Inflation is likely to reduce the purchasing power of households. Political risk is also high this year, and while similar events appear to have had almost no economic impact in the UK and US last year, it is worth remembering that Europe is in a more fragile situation and has suffered more from similar events in the past, even causing recessions."

“Nevertheless, fundamentals in Europe are also improving. Good momentum has built up in the labour market, with employment growing at rates not seen since 2007. Wages are lagging behind, but should accelerate in due course. So despite the political risk in 2017, a period of optimism is long overdue for Europe amongst the investor community.”

China

2016 actual (Datastream): 2.0%
2017 Schroders forecast: 2.5%
2018 Schroders forecast: 2.3%
2018 Consensus forecast: 2.0%

China’s inflation has mostly held at around 2% since 2014, higher than most Western nations. Its low in 2016 was 1.3%, rising to 2.5% by January. Unlike the US, China could be a deflationary force in the global economy this year.

Relations between China and the West are frayed, with Trump accusing China of being a currency manipulator, by letting the renminbi fall in value and undermining US international competiveness.

But according to Wade, China is doing the opposite: “What we’re seeing is that China has been reducing its foreign exchange reserves, which is actually supporting the currency.”

Should Trump name China as a currency manipulator, it may then decide to stop purchasing its own currency. Should that occur, the renminbi would devalue further and cause the cost of Chinese exports to fall, exporting a deflationary effect around the world.

Wade continued: “If the Chinese government stopped trying to control the renminbi, then we could expect it to fall a further 10-20%, therefore becoming a major deflationary force. Watch out what China does.”

What next?

Rising inflation in the US could encourage the Federal Reserve to raise interest rates in an attempt to cool the economy. It is already expected to raise rates twice in 2017, up to 1.25%, followed by further increases to 2.0% by the end of 2018.

The Bank of England, in contrast, is not expected to act this year or next.

Markets have been affected, with the prices of bonds falling in recent months. Rising inflation makes today’s bond yields look less appealing and prices fall. Stockmarket investors, on the other hand, expect inflation to help improve company profits.

A poll at a Schroders Investment Conference in late January asked investment intermediaries what the biggest risk was for markets in 2017. Politics was the biggest concern, but only 9% regarded higher inflation as the greatest danger.

Johanna Kyrklund, Head of Multi-Asset Investments at Schroders, said: “We think inflation is likely to surprise on the upside and at the moment this is not reflected in markets or portfolios.”


Important Information: The views and opinions contained herein are those of Ben Arnold, Investment Writer, Keith Wade, Chief Economist and Johanna Kyrklund, Head of Multi-Asset Investments and may not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. This material is intended to be for information purposes only and is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide and should not be relied on for accounting, legal or tax advice, or investment recommendations. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Past performance is not a guide to future performance and may not be repeated. The value of investments and the income from them may go down as well as up and investors may not get back the amounts originally invested. All investments involve risks including the risk of possible loss of principal. Information herein is believed to be reliable but Schroders does not warrant its completeness or accuracy. Reliance should not be placed on the views and information in this document when taking individual investment and/or strategic decisions. Some information quoted was obtained from external sources we consider to be reliable. No responsibility can be accepted for errors of fact obtained from third parties, and this data may change with market conditions. This does not exclude any duty or liability that Schroders has to its customers under any regulatory system. Regions/sectors shown for illustrative purposes only and should not be viewed as a recommendation to buy/sell. The opinions in this document include some forecasted views. We believe we are basing our expectations and beliefs on reasonable assumptions within the bounds of what we currently know. However, there is no guarantee than any forecasts or opinions will be realised. These views and opinions may change.

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