Reflation: The Sequel

Recently I’ve noticed market commentators, the media and institutional investors starting to acknowledge not only the “synchronous global recovery” theme that we at Morgan Stanley’s Global Investment Committee were highlighting back in early 2016, but also the idea that corporate earnings are the main reason for the global equity rally.

We’re also stopped receiving pushback on our call for higher valuations and there’s less hand-wringing over political or even geopolitical concerns; our view has been consistently that the business cycle trumps politics.

As long as we see accelerating growth and stable financial conditions, equity markets around the world will likely continue to perform well. While investor sentiment is far from exuberant, we can say it's no longer negative.

All that said, the one part of our narrative that has yet to catch on is that inflation is not dead and may be stirring, getting ready for a more significant run next year.

Fixed income investors have essentially given up on inflation ever coming back since little upside risk of that happening is currently priced into interest rate markets. Even the Federal Reserve seems to be perplexed at why inflation remains so low in the face of full employment and an economy that seems to be doing just fine.

Everywhere I travel in the U.S., I see a boom as measured by the lack of open seats on airplanes, sold-out hotels and crowded restaurants, not to mention the almost out-of-control construction activity in every city. These are exactly the kinds of things that lead to inflation, but we aren’t in the business of guessing. Instead, we have leading indicators to help us navigate.

The year-over-year change in money velocity is our favorite indicator because it’s been quite accurate for more than 20 years. As the chart below shows, money velocity (dark blue line) typically leads core inflation (light blue line) by 21 months. It clearly predicted a precipitous fall in core inflation this year. 

Our Favorite Indicator Points Toward Rising Inflation

So, to hear institutional investors and even Federal Reserve officials talk about why they're perplexed about this year's drop in inflation actually confuses us. Many drivers of inflation work with a long lag, so focusing on current data can lead to some wrong conclusions. The good news is that our indicator is suggesting we are likely to see a near-term trough in core inflation before it ramps up into next year toward the Fed’s 2% goal.

You might be asking, "Why this is good news? Isn’t inflation a bad thing? Who likes higher prices?" Generally speaking, high inflation is a bad thing and for those of us who can remember the 1970s, we know how destructive it can be. However, inflation that is too low or outright deflation can be just as destructive—just ask Japan.

The other factor that must be considered is the fact that there is still a tremendous amount of outstanding debt in the world, especially at the government and corporate level. In such a world, deflation is like kryptonite. So, anytime inflation looks like it’s breaking lower—like this year—it makes global investors and markets quite nervous. Therefore, a signal that inflation is bottoming should be welcomed by global equity investors.

The other reason rising inflation is a good thing is that it suggests secular stagnation—a permanent, low-growth regime—is ending. Back in the summer of 2016 we took an aggressive stance that cited Brexit as an important bottom for growth and inflation expectations—that is, the end of secular stagnation. We viewed the enormous flight to safety immediately after the referendum as a final capitulation to this long-standing consensus view.

Because they are emotionally charged, political events have a way of faking out even the smartest investors. We view the election of Donald Trump in the same manner because U.S. markets understand this maxim quite well even if investors remain confused. Inflation expectations clearly bottomed with the resynchronization of global growth in February 2016. The affirmative Brexit referendum simply served to retest that bottom, but without new lows. 

Reflation Part II Appears to Be Underway
(U.S. Five Year Inflation Breakevens)

Last fall, reflation became the rage as many governments focused on progrowth policies thanks to political pressure that culminated with the U.S. elections in November. As usual, investors then became too excited and bid inflation expectations too high, along with assets that benefit from higher growth and interest rates—i.e., banks, small-cap stocks, energy and industrials. After trading down in the middle part of the year, those assets reasserted their leadership in August and should continue to be good areas to look for further outperformance until the end of the cycle. 

Note: This article first appeared in the October 2017 edition of “Positioning,” a publication of the Global Investment Committee, which is available on request. For more information, talk with your Morgan Stanley Financial Advisor, or find one using the locator below.