Back to the future?

The economy always gets its revenge in the end” Raymond Barre, the former French Prime Minister, declared in his memoirs1 when recalling the impact on economic life of political decisions… Does this observation from the last century also apply to the work accomplished by central banks over the last 10 years?

After combating fears of deflation over this period, monetary authorities almost succeeded in letting us forget that inflation existed. Few investment strategies still indicated distrust early this year even though everyone is now wondering about the possibility of a return of a plague that had disappeared in the 70s.

The bond market, more sensitive to future value in use of money lent, was naturally the first to be concerned. After fluctuating since the election of Donald Trump between 2.00 and 2.60%, the yield of US 10-year treasury notes is today nearly 3.00%, a four-year high. Government bond yields in France have also risen above a level not seen (1.00%) since the period of pre-electoral anxiety.

This increase in long-term rates has triggered renewed volatility in the market for risk assets. To such an extent that the term “volatility” has reappeared in headlines, particularly since its CBOE Volatility Index (VIX)2 is now at 2008 levels above 50%. Volatility represents the velocity of market price swings. While in 2017, there were only 8 trading sessions of the S&P 500 showing variances of more or less 1%, this year we have already seen 13! In fact, it was 2017 with its spectacular absence of volatility – accompanied by its plethora of structured products betting on the cycle’s continuation – that were “abnormal”: an increase in prices exceeding 2% in the United States was simply the trigger for a return to normal.

While the return of inflation may still seem uncertain, the reasons for its likelihood are numerous: synchronous worldwide growth, declining unemployment, increases in wages at times particularly pronounced as in the United States (+11% for the minimum salary at Wells Fargo), the worldwide increase in commodity prices or China’s reduced ability to export its own price pressures.

Wage increases combined with an officially low unemployment rate are the natural and conventional explanations for the return to inflation. The picture in Europe is not much different than in the United States. It striking to note that IG Metall, the German metalworkers’ union with a history of supporting wage moderation, just obtained a general increase of 4.3%, whereas the increase at LUFTHANSA might be as much as 6%. A phenomenon also impacting France where, if one believes in the analysis of web search data, the number of searches for the term “salary increase” have reached levels not experienced for the last 15 years.

In consequence, after believing in its complete disappearance, will investors now convince themselves that a dangerous cycle of inflation lays ahead? No doubt not as rapidly as recent market volatility might lead them to believe… In contrast, the warning has been issued and we will be focusing on detecting and keeping a close eye on those companies capable of adjusting their prices and those which, as financial companies, will be the logical beneficiaries of rising long-term rates.

“This report of my death was an exaggeration.” commented Mark Twain following the announcement in the press that he had died…There is little risk in making the same observation about the market cycles or inflation!

Didier Le Menestrel

L’expérience du pouvoir, Fayard, 2007
2  The index for measuring stock market’s expectation of volatility implied by S&P 500.