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Why you shouldn’t ignore inflation even if it is low

30 August 2018

Legal & General Investment Management’s John Roe shares his views on global inflation and where he sees it heading along with its associated risks.

By Henry Scroggs,

Reporter, FE Trustnet

The absence of significant inflation has been one of the more surprising aspects of the late part of the cycle, but it is not something that investors can safely ignore, according to Legal & General Investment Management’s John Roe.

While global inflation may have risen from the lows witnessed during 2016, levels remain behind expectations for many economists and analysts.

As of June this year, current levels of global inflation are sitting just below 2.8 per cent, according to data from the Organisation for Economic Co-operation and Development (OECD).

And it is this lack of inflation in the global economy that is the “thing that’s really surprised us”, according to Roe, head of multi-asset funds at Legal & General.

Global inflation annual growth rate (%)

 

Source: OECD

Despite much talk among investors about the end of the cycle, Roe – who sits with the firm’s asset allocation team – said it is the deflationary story that has extended the cycle so far and continues to do so.

“That’s been the biggest surprise to economists over the last five years,” he said. “It’s allowed much looser monetary policy for longer than people would have anticipated.”

The structural deflation inherent in markets is all the more surprising given the low rates of unemployment being witnessed in developed markets currently.

Indeed, in both the US and the UK unemployment levels have touched record lows leaving many to wonder why it hasn’t been accompanied by wage inflation.

“Why is it that with so much stimulus and such low unemployment we’ve not seen more wage inflation?” he asked.

One of the biggest drivers of deflation in recent years has been technology, with Roe highlighting a number of reasons why.

“I think the first of those is that stuff’s free and free stuff just doesn’t get captured by GDP because it’s a form of consumer surplus,” the manager said.


An example of the deflationary companies offering free services in the technology space is one of the best-known names out there, Google.

“We get value from Google, and search engines generally, but we don’t pay anything for them at the point of delivery,” he said. “If we all got paid more and we all spent money on search engines, then everyone would look at that and say, ‘well that’s great, GDP’s bigger, income’s bigger and they’re spending it on Google.”

However, because Google is not a service paid for at the point of delivery it is classed as a consumer surplus. It may just be one example, but Roe said that consumers place real value on search engines.

“There was a paper that came out a year or two ago, that looked at what Americans would pay for certain free goods,” the Legal & General manager said. “They came to the conclusion that the average American would pay something like $17,000 for search engines.”

Share price of Alphabet (Google parent company) over 5yrs in USD

 

Source: Google Finance

Roe’s second reason that technology is a cause of structural deflation is that, the more technology gets included in our basket of goods, the more inflation gets overstated.

He said: “This is a big debate because some academics have said, ‘no, inflation has always been overstated’.

“So, inflation is even lower, which would mean structurally peoples’ mindset would be more deflationary because the inflation they’re experiencing is lower than the official number. You can argue this has always been true.”

The third and final reason is the ability to work from home that has been made possible because of technology.

“Flexible working conditions really matter to people and there was some work done by the NBER [National Bureau of Economic Research] in the US that looked at what people might be willing to pay for home working,” Roe explained.

“And the flexibility of working might be worth up to $800 to the average American individual.”

The manager said this a quite a large amount, a few per cent of peoples’ annual pay, and that some people place more value nowadays on being able to leave work earlier on Wednesday to play football or leave earlier on Friday to go away for the weekend than pushing for that extra bit on your pay packet.

He said: “What people care about more has maybe changed to those things that improve your quality of life rather than the amount of money each month. The fact is that technology has made that feasible.”


 

“So, that’s the kind-of structural deflationary story and that’s what has allowed us to be more positive,” Roe summarised.

It is this structural deflation, alongside a revision of economic data and some lean inventory data coming out of the US, that means Roe is still supportive of current economic conditions.

However, the manager cautioned that sharper-than-expected inflation is actually one of the biggest risks that he sees at the moment.

This is despite the fact that it isn’t getting much attention because “it’s not exciting and Donald Trump doesn’t really tweet about it”, said the Legal & General head of multi-asset funds.

A lot of the “market chatter” tends to be surrounding the ongoing trade war, whose downside risks are overaccentuated in Roe’s opinion.

But on a medium-term perspective, he said he sees a sharper-than-expected increase in inflation as just as big of a risk as the trade spat.

Roe said: “It would cause faster-than-expected US monetary policy tightening. And when the US tightens monetary policy, it has spill over implications for their own assets.”

“But it also has implications for emerging markets and other countries because their cost of funding goes up.”

This increase in funding costs is also the reason why a stronger dollar is a big risk for those countries, like the emerging markets, that borrow heavily in dollars.

Dollar vs other currencies over 1yr

 

Source: FE Analytics

Going back to inflation, the multi-asset manager said all it takes is a couple of months of inflation to get people talking about it and questioning at what point does the US Federal Reserve have to step in.

If inflation were to happen, Roe believes it would be in the US or the UK because of their low unemployment and populist policies such as tariffs and less immigration that tend to be inflationary.

“Tariffs push up the price of goods, that’s no surprise,” he said. “Removing or reducing immigration pushes up wages by reducing the availability of labour. These combinations of things can help stoke inflation.”

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