Productivity, Inflation And The Path Of Rates

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by: Neuberger Berman

By Erik Knutzen, Chief Investment Officer - Multi-Asset Class

A capex boost could raise productivity, keep a lid on inflation and further extend the current cycle.

One of the important economic measures I wrote about earlier this year was the Inflation Expectations Gauge. If the 10-year U.S. breakeven rate rises above 2.5%, I said, the Federal Reserve might have to increase the pace of its rate hikes.

Over the following weeks, it looked ready to test that level. By mid-May, however, it was stalling at 2.2%, and it almost fell back through 2% at the start of June.

Last week, in line with expectations, the Federal Reserve hiked rates, freed itself from its "low-for-longer" forward guidance and lifted its "dot plot" a little higher. The European Central Bank also followed the script, confirming that it would end its quantitative easing purchases by the end of the year, subject to data supporting its inflation outlook - which it revised upwards. It is a good time to ask why markets have become so tentative in their inflation expectations, and what that implies about the length of this business cycle and the path of rates.

Where Is Inflation?

Realized inflation has indeed been weaker than expected so far this year.

Unemployment is at levels unseen since 2000 in the U.S., the early 1990s in Japan and 2007 in Europe. Commodity prices have been rising for 12 months. The business cycle seems to be maturing, with robust equity valuations and tight credit spreads, and yet, the U.S. has enacted a fiscal stimulus worth $280 billion in 2018 alone.

Against this backdrop, it is surprising that U.S. core consumer price inflation (CPI) sits at just 2.0-2.2%. The Fed's favored measure of inflation, year-over-year growth in core personal consumption expenditures (PCE), has risen from 1.5% to 1.8% but remains below its 2% target. Inflation appears to have recovered from its dip last year, but does not register the full pressure that seems to be building beneath it.

Perhaps we should think again about that huge fiscal stimulus. A big chunk of it is coming in the form of tax cuts for corporations. Some of that windfall will be paid out in higher wages, dividends and share buybacks - all potentially inflationary. However, first- and second-quarter reports suggest that at least a portion of it is being ploughed into capital expenditure - which is potentially disinflationary.

Capex and Productivity

How can spending more be disinflationary? Investing in new machines and technology should improve productivity. Improved productivity means more economic output for the same number of hours worked, dollars paid in wages and raw materials purchased. That, in turn, gives the economy the capacity to grow just a little more without stoking inflation.

The official data tell us that productivity has been declining for years. But that is difficult to square with the steady growth and low inflation we have enjoyed for the past three decades. "You can see the computer age everywhere but in the productivity statistics," wrote Nobel laureate Robert Solow back in 1987, when 64K home computers were a novelty. Well, productivity growth is apparently even slower today, in the age of the smartphone.

Do our statistics fail to capture the impact of smartphones and artificial intelligence as clearly as they captured the impact of trains, trucks and intercontinental flight? Or is the surge in productivity just around the corner? Academics will continue to debate this puzzle. For investors, it is enough to recognize the correlation between technological advances and low inflation growth - and that the leaders in this year's capex spending have been in the energy and technology sectors.

Keep Checking That Gauge

It is far too early to say that the investments made in the first half of this year have boosted productivity and taken the steam out of inflation. However, it is not too early to ask whether they might keep the lid on over the next 12-18 months. Notwithstanding the gentle nudge its new chairman gave us last week, well-behaved inflation would give the Fed some latitude to continue normalizing rates and winding down its balance sheet, while soothing markets with dovish forecasts and pronouncements.

Ultimately, that could extend this already long cycle even further. Some are already talking about a return to the "Goldilocks" environment of 2017. We would not go that far, but it is good to remember that the economy can surprise us with its capacity for non-inflationary expansion. Keep checking that gauge.

In Case You Missed It

  • U.S. Consumer Price Index: +0.2% in May month over month and +2.8% year over year (core CPI increased 0.2% month over month and 2.2% year over year)
  • U.S. Producer Price Index: +0.5% in May month over month and +3.1% year over year
  • FOMC Meeting: Increased the Federal funds rate by 25 basis points to 1.75-2.0%
  • U.S. Retail Sales: +0.8% in May
  • European Central Bank Policy Meeting: The ECB left its policy settings on hold and plans to end its bond buying program at the end of the year.
  • Eurozone Consumer Price Index: +0.5% in May month over month and +1.9% year over year
  • Bank of Japan Statement on Monetary Policy: The BoJ will keep its short-term interest rate target unchanged.

What to Watch For

  • Monday, 6/18:
    • NAHB Housing Market Index
  • Tuesday, 6/19:
    • U.S. Housing Starts and Building Permits
  • Wednesday, 6/20:
    • U.S. Existing Home Sales
  • Thursday, 6/21:
    • Japan Consumer Price Index

- Andrew White, Investment Strategy Group

Statistics on the Current State of the Market - as of June 15, 2018

Market Index WTD MTD YTD
Equity
S&P 500 Index 0.1% 2.8% 4.9%
Russell 1000 Index 0.1% 2.9% 5.2%
Russell 1000 Growth Index 0.7% 3.8% 10.3%
Russell 1000 Value Index -0.6% 1.8% -0.1%
Russell 2000 Index 0.7% 3.1% 10.3%
MSCI World Index -0.1% 2.1% 2.8%
MSCI EAFE Index -0.5% 0.8% -0.4%
MSCI Emerging Markets Index -1.8% -0.5% -3.0%
STOXX Europe 600 -0.2% 1.2% -1.3%
FTSE 100 Index -0.6% -0.4% 1.5%
TOPIX 0.4% 2.5% -0.5%
CSI 300 Index -0.5% -0.8% -6.2%
Fixed Income & Currency
Citigroup 2-Year Treasury Index -0.1% -0.2% -0.1%
Citigroup 10-Year Treasury Index 0.2% -0.8% -3.4%
Bloomberg Barclays Municipal Bond Index 0.0% -0.2% -0.5%
Bloomberg Barclays US Aggregate Bond Index 0.1% -0.5% -1.9%
Bloomberg Barclays Global Aggregate Index -0.3% -0.7% -1.7%
S&P/LSTA U.S. Leveraged Loan 100 Index 0.0% 0.3% 2.1%
ICE BofA Merrill Lynch U.S. High Yield Index 0.4% 0.9% 0.7%
ICE BofA Merrill Lynch Global High Yield Index 0.1% 0.4% -1.0%
JP Morgan EMBI Global Diversified Index -0.6% -1.1% -5.1%
JP Morgan GBI-EM Global Diversified Index -1.9% -2.8% -6.4%
U.S. Dollar per British Pounds -0.9% -0.1% -1.8%
U.S. Dollar per Euro -1.3% -0.5% -3.3%
U.S. Dollar per Japanese Yen -1.0% -1.7% 2.0%
Real & Alternative Assets
Alerian MLP Index -2.7% -1.8% -0.9%
FTSE EPRA/NAREIT North America Index -0.6% 1.0% -1.2%
FTSE EPRA/NAREIT Global Index -0.8% 0.6% 0.0%
Bloomberg Commodity Index -2.5% -3.2% 0.3%
Gold (NYM $/ozt) Continuous Future -1.9% -2.0% -2.4%
Crude Oil (NYM $/bbl) Continuous Future -1.0% -3.0% 7.7%

(Source: FactSet, Neuberger Berman)

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