An Inflation and Policy Backdrop Unlike What Many Expected Affords Opportunity
Rick Rieder and Russ Brownback argue that as the conventional wisdom in policy and investment circles surrounding prospects for growth and inflation have shifted in 2019, so too have investment opportunities.
We think 2018 will be remembered as a rolling, cross-asset-class bear market that increased in intensity all year. There were numerous influences that drove this price action, but chief among them was a market obsession with the prospect of a pernicious inflationary paradigm, which was thought to be a near certain end-game for this economic cycle. Indeed, markets priced in Federal Reserve policy tightening as if it were on autopilot, thinking it was necessary to ensure that inflation’s “inevitable” comeuppance would be contained. We were vocal critics of this thinking last year and remain convinced that permanent secular dynamics have tamed traditional cyclical inflation on a global basis. A more nuanced analysis of increasingly tepid readings of growth and inflation reveals a larger, and underappreciated, deficit relative to policy targets than understood by conventional wisdom.
Markets price more benign policy/inflation, but details matter
Fortunately, the 2019 market narrative is unfolding in a more benign fashion as acutely tightened financial conditions in the fourth quarter of 2018 and still-slowing global growth have allowed markets to price in a forward path of policy pragmatism that acknowledges these headwinds. Specifically, the U.S. Fed has pivoted to a paradigm of patience, in deference to the lowest long-term inflation expectations in more than 50 years (see graph) and the notion that economy-wide financing costs for investment are appropriately aligned with potential growth rates today. Together, these influences construct a convincing equilibrium, upon which Fed policy patience is appropriately perched.
Moreover, a comprehensive analysis of growth and inflation must include a deeper dive into the details of data than simple observations of systemic economic averages. For example, the regional dispersion of U.S. economic data continues to challenge the value of what any “average” number would suggest. Each region (and even some states in and of themselves) has the make-up of what could be an entirely different and separate country. Specifically, five states alone (California, New York, Texas, Florida, and Illinois) together contribute 40% to U.S. GDP, an immense dichotomy to the output of just about every other state. More telling still is the most recent headline CPI inflation print of 1.6%, which would be 50 basis points lower if the Western region of the country were excluded, amounting to the greatest divergence in regional rates of inflation in years. These dispersions raise the bar for the justification of every incremental policy change, since no single policy initiative can possibly be wholly appropriate for every geographic area.