In focus: U.S. inflationary forces

17 September, 2020

Frances Donald, Chief Economist

Framed as a subtle shift in policy, U.S. Federal Reserve (Fed) Chair Jerome Powell recently announced an important, if widely expected, shift in the way it thinks about employment, inflation, and interest rates—with far-reaching implications for investors.

When the Fed announced its decision to move toward “a flexible form of average inflation targeting,” effectively confirming the central bank’s desire to overshoot its official 2% inflation target,¹ the markets barely budged. However, it wouldn’t be wise to mistake Wall Street’s subdued response for disinterest—it’s an announcement that’s very relevant to investors, particularly those interested in inflation dynamics, specifically, upside surprises to inflation over the next three to six months. In our view, a structurally dovish Fed combined with stronger inflation data ahead effectively moves inflation expectations higher and moves real rates lower.

The inflation versus deflation discussion isn’t necessarily binary in nature; it’s filled with nuance, counterforces, and a number of unknowns. In truth, inflationary and deflationary pressures are at play simultaneously and as these opposing forces fluctuate, investors will likely go through periods during which they worry about deflation and other periods during which they’ll fret about inflation. These are important investment considerations with different implications that could lead to different investment outcomes. In our view, there are four key ideas that are central to any debate about inflation.

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Framing the inflation debate: four key ideas

Timelines matter

We believe that a great deal of confusion surrounding the U.S. inflation outlook can be traced to difficulties in delineating the near-term inflation trajectory from its long-term path. There are inflationary and deflationary forces in every time horizon, but one will inevitably outweigh the other at different moments.
Market expectations

It isn’t just the level of inflation that markets care about: The type of inflation that’s being generated (cost push versus demand pull) and the extent to which it deviates from expectations are just as important. It’s also worth noting that what’s considered unacceptably high inflation to one person can be different to another—for instance, millennials and Generation Z have never seen 3% inflation in their lifetime. Critically, it’s important to recognize that mild to moderate inflation needn’t be strictly negative for equities.
Regime shifts

We may be in the midst of a structural regime shift in terms of the drivers of inflation. We expect future inflation to be driven more by active fiscal policy and deglobalization, and less by monetary policy. Classic inflation models are therefore far less relevant and shouldn’t be used to predict future inflationary pressures. This suggests old-school correlations, such as the Phillips curve, might not be as useful as they once were. And remember, economists generally don’t have a good track record at predicting (or understanding) inflation.
Measurement issues

It’s also important to note that classic CPI measures weren’t able to accurately measure the cost of living in the United States for some time now—it isn’t a new issue and we believe it’s likely to be even less accurate now. Policymakers are increasingly looking to address this problem, and it’s likely that both formal and informal measurements of inflation will need to be adjusted in the coming years, particularly with respect to housing costs and asset prices, which would likely push measured inflation higher.

10 near-term price pressures (next three to six months)

Given that the United States is in the middle of a pronounced recession, the idea of rising inflationary pressure within the next three to six months might seem counterintuitive. Shouldn’t a recession lead to demand deflation typically associated with large output gaps? In theory, yes, but the current economic shock is fundamentally different from a regular recession, and we see 10 key near-term inflationary pressures that are likely to contribute to inflation moving quickly back to 2% or above before year end. Given the economy’s weak growth profile, we think it’s more accurate to characterize this tactical period as stagflation.

Although the United States and most economies worldwide are experiencing a massive demand shock, most data suggests that demand is coming back more quickly than supply. Unlike previous recessions, we expect the supply shock to be both more persistent and more painful. This is a scenario that’s fundamentally inflationary, although there’s a lid on how high inflation can rise when the output gap remains open and demand is still quite weak.
The Fed’s shift toward average inflation targeting should help to keep inflation expectations much closer to 2%, potentially putting a floor under how far prices can fall. In addition, the Fed (and most economists) have long believed that inflation expectations themselves play a role in future actual inflation.²
We expect U.S. consumers to deploy the sizable buildup in personal savings accrued over the past few months—a result of government support such as stimulus checks and unemployment insurance top-ups. This is likely to increase money velocity temporarily.
Disrupted supply chains and a reduction in trade activity have contributed to reduced supply, but inventory shortages in several core products have exacerbated the impact. We expect this to persist until business confidence revs up in 2021. Until then, cost-push inflation is likely to materialize, presenting a new challenge for the U.S. economy. Tariffs on imports introduced over the last few years will also likely support price rises.
Prices for key components in the CPI basket such as air transit, hotels, and apparel bottomed in July,³ which suggests the initially deflationary impact of the pandemic is now fading and is no longer directly contributing to negative month-over-month inflation prints.
Commodity prices have risen sharply, including lumber, copper, and iron ore, over the past four months. Oil prices are no longer declining in year-over-year terms.
The U.S. dollar has weakened ~7% since its peak in March.³ It’s a development that’s supportive of U.S. inflation, with a small lag.
We’re seeing evidence that labor costs are rising, both through the need for top-up pay for essential workers and higher wages to lure workers back into work. While this is likely the most transitory of inflationary pressures, we believe investors should also factor in the possibility of a higher federal minimum wage in the next year.
We expect corporates to enjoy higher pricing power in an environment of reduced supply—this is particularly true for the goods sector, although the effect may not be uniform across all sectors. Put differently, the rising costs of inputs like intermediary goods and labor can be passed on, at least in part, to end consumers.
We expect shelter costs to rise as U.S. housing continues to perform well thanks to low rates. There is also a general consensus that housing inflation in the United States might be under calculated in the CPI and statistical bureaus have discussed improving the calculation. It’s worth noting that shelter accounts for 34% of the CPI basket.

Inflation could be underpriced

While markets may already be awakening to the inflation upside narrative, we see evidence that inflation may still be underpriced. U.S. bond markets may have nudged inflation expectations higher, but we believe the rise has more to do with improved liquidity conditions and the term premium than a surge in expectations of higher prices. In addition, both the Minneapolis Fed’s measure of market expectations for inflation (which remains extremely asymmetric, suggesting a 22% probability of inflation falling below 1% and only a 9% probability of inflation rising above 3%) and the Citi Inflation Surprise Index (which remains below 0) suggests there’s considerable scope for an upside surprise.

Market implications

Given the Fed’s formal shift to average inflation targeting, the bond markets aren’t likely to associate higher inflation with higher nominal rates—at least not for now. As a result, as inflation rises, nominal yields are likely to remain around current levels even as real rates fall deeper into negative territory.

We also expect the yield curve to continue to steepen, particularly between the belly of the curve and the long end—the Fed’s constant references to yield curve control, which it isn’t likely to implement just yet, has the effect of keeping the front end of the yield low. Finally, mild inflation is historically correlated with a positive rerating of equities (well, until about 3%). In our view, investors shouldn’t view higher inflation by itself as a cause for an equity market sell-off. For the time being, it might be useful for investors to start embracing a new reality and get used to slightly higher levels of nominal inflation, even if it makes us all slightly uncomfortable.

Timing the inflation call

We believe it can be helpful to visualize how inflationary and disinflationary pressures can evolve over three different timelines: within the next 3 to 6 months, within the next 18 months, and beyond the next 3 years. In our view, it’d make sense for investors to draw a clear distinction between long-term deflationary pressures and short-term inflationary pressures given the evolving macro landscape that we find ourselves in.

Download full PDF

1 “New Economic Challenges and the Fed's Monetary Policy Review,” federalreserve.gov, August 27, 2020.

2 “Measures of Expected Inflation,” Federal Reserve Bank of Cleveland, accessed August 27, 2020.

3 Bloomberg, as of August 27, 2020.

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Read more
The implications of recent trade policies on Greater China equities

The latest development in tariff-centric trading policies has been on the market’s radar, with a recent retaliatory announcement by China that imposed a 34% levy on all US-imported goods. In this note, we examine the measures more deeply and assess their impact on Greater China equities.

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Quick thoughts on US reciprocal tariffs

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Certain sub-funds with significant exposure to Renminbi (“RMB”) bonds/equity/assets or emerging markets, may involve debt instrument, credit/counterparty, concentration, liquidity, volatility, currency, tax, economic, foreign exchange/multi-currency conversion, down-grading, regulatory and political risks and these risks could be substantially higher than the risks normally associated with the world's more established markets.
A bond sub-fund may hold a significant portion of assets in deposits if there are not sufficient RMB instruments for it to invest in. This may adversely affect its return and performance.
Certain sub-funds using invest directly in debt instruments/shares via QFII regime, the Bond Connect and/or the Foreign Access Regime are subject to various requirements and restrictions under the laws of Mainland China related to investment in QFII and/or China Interbank Bond Market and custodial risks.
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Certain sub-funds may have significant concentrated exposures to particular industry sectors and geography's, which subjects investors to concentration and equity market risk.
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General Risk Disclosure

Funds offered on this platform may invest in equity, fixed income securities, exchange-traded funds, collective investment schemes and/or other instruments, including derivatives, and each of which has its specific investment objective/ policy with its specific features and different risk profile.
Distribution of dividends, the frequency of distribution and the amount/rate of dividends are not guaranteed. Dividend of certain share/unit classes, at the fund or the investment manager’s discretion, may be paid out of capital or gross income while charging / paying all or part of its fees and expenses out of its capital. This amounts to a return or withdrawal of part of an investor’s original investment or from any capital gains attributable to that original investment, and may result in an immediate reduction of the net asset value per share/unit of the respective share/unit classes after the distribution date.
Some funds may invest in bonds or debt securities which may be subject to credit, liquidity, counterparty and market risks.
Some funds may invest in non-investment grade bonds and unrated securities which may be subject to greater credit and liquidity risks, and may be more volatile than higher rated securities. Some funds may invest in investment grade debt securities, which may be subject to ratings downgrades by the rating agencies that may affect the net asset value of the fund.
Some funds may invest in derivative instruments which may involve additional risks. (For example, leverage may cause greater volatility.)
Some funds may make extensive use of derivatives including more complex derivative instruments or strategies to achieve the investment objective, this may give rise to additional exposure in that performance may rise or fall more than it would have done otherwise. In adverse situations, the fund’s use of derivative instruments may become ineffective and the fund may suffer significant losses. The use of derivatives may give rise to leverage, liquidity, counterparty and valuation risks.
Some funds may invest in emerging economies or markets, where special risks, including liquidity, volatility, government policies, taxation, currency, currency repatriation, political and regulatory risks, may be substantially higher than the risks normally associated with more developed economies or markets.
Some funds may invest in securities of small and/or medium sized companies in the relevant markets. This can involve greater risk than is customarily associated with investments in larger and more established companies.
Some funds may invest in a single country/region and/or a particular industry sector which may be concentrated and subject to greater risks than diversified investments in several countries and/or regions and across sectors.
Some funds may invest directly in certain China A shares via the Stock Connect, which may involve risks related to investments via the Stock Connect and Mainland China investment.
Some funds may have significant exposure to Renminbi ("RMB") bonds/equity/assets or emerging markets, which will be subject to debt instrument, credit/counterparty, concentration, liquidity, volatility, currency, tax, economic, foreign exchange/multi-currency conversion, down-grading, regulatory and political risks and these risks could be substantially higher than the risks normally associated with more established markets.
Some funds with significant exposure to RMB bonds/equity/assets may hold a significant portion of assets in deposits if there are not sufficient RMB instruments to invest in. This may adversely affect the funds’ return and performance.
Some funds using Qualified Foreign Institutional Investor (“QFII”) quota to invest directly in debt instruments/shares in Mainland China may be subject to various requirements and restrictions under the laws of Mainland China related to QFII investment and custodial risks.
Some funds are subject to the risks of investing in other funds and the risks relating to asset allocation strategy and/or downside risk management process.
As RMB is not freely convertible, currency conversion is subject to exchange controls and restrictions. There can be no assurance that RMB will not be subject to devaluation. Insufficient amount of RMB for currency conversion or devaluation of RMB could adversely affect the value of investors’ investments in the RMB denominated class(es) of certain funds. The “Dim Sum” bond market is still a relatively small market which is more susceptible to volatility and illiquidity. Due to RMB concentration risk, the value of the funds with substantial RMB exposure may be more volatile than that of a fund having a more diverse portfolio of investments.
Some funds’ performance will be closely tied to the economic, political, regulatory, geopolitical, market, currency or other conditions in the European Economic Area and may be subject to increased liquidity, price, and foreign exchange risk.
Some funds may invest in Russia and some investments in Russian securities may be unlisted securities not dealt on a regulated market. The Russian market presents specific risks in relation to the settlement and safekeeping of securities.
Investment involves risk. Investors may expose to capital loss and should not invest solely based on the information on this website alone and should read the offering documents for details including the associated risk factors, charges and features of the funds and their share/unit classes. Past performance information is not indicative of future performance.

Manulife Global Fund

Manulife Global Fund is an umbrella fund comprising a number of sub-funds investing in equity and/or fixed income securities, each of which has a different investment objective and risk profile and may involve equity market, geographical concentration, sovereign debt, liquidity, volatility, credit downgrade, interest rate, counterparty risks. Certain investors may also be subject to the risk relating to RMB hedged share class.
The relevant distributing class of the sub-funds does not guarantee distribution of dividends, the frequency of distribution and the amount/rate of dividends. Dividends may be paid out of income, realized capital gains and/or out of capital of certain sub-funds in respect of Inc share class(es). Dividends may be paid out of realized capital gains, capital and/or gross income while charging all or part of their fees and expenses to capital (i.e. payment of fees and expenses out of capital) in respect of MDIST (G), R MDIST (G) and F MDIST (G) share class(es). Dividends paid out of capital of these sub-funds amounts to a return or withdrawal of part of the amount of an investor’s original investment or from any capital gains attributable to that original investment and may result in an immediate decrease in the net asset value per share in respect of such class(es) of the sub-funds. Fixed yield share classes pay out a pre-determined annualized fixed percentage of their NAV, which can be adjusted by the Directors with at least one month’s prior notice, do not entirely reflect the actual or expected income or performance of the Fund. These distributions may exceed the actual income, leading to capital erosion, especially during negative returns or losses, and may reduce future capital growth. A positive distribution yield does not guarantee a positive return, and the absolute distributions vary with the NAV, resulting in fluctuating monthly payouts for investors.
Certain sub-funds invest in emerging economies or markets, where special risks, including liquidity, volatility, government policies, taxation, currency, currency repatriation, political and regulatory risks, may be substantially higher than the risks normally associated with more developed economies or markets.
Certain sub-funds invest in securities of small and medium sized companies in the relevant markets. This can involve greater risk than is customarily associated with investments in larger and more established companies.
Certain sub-funds concentrate their investments in a single country and/or a particular industry sector are subject to greater risks than diversified investments in several countries and/or regions and across sectors.
Certain sub-funds may invest directly in certain China A shares via Stock Connect, which may involve in risk related to Investments via Stock Connect and Mainland China investment.
Investment involves risk. The sub-funds may expose their investors to capital loss. Investors should not invest solely based on this material and should read the offering document for details including the risk factors, charges and features of the sub-funds and their share classes.
Each sub-fund intends to use financial derivative instruments (“FDIs”) for investment, efficient portfolio management and/or hedging purposes. The use of FDIs exposes the Fund to additional risks, including counterparty/credit risk, liquidity risk, valuation risk, volatility risk and over-the-counter transaction risk.
Given RMB is currently not a freely convertible currency, payment of redemptions and/or dividend payment in RMB may be delayed due to the exchange controls and restrictions applicable to RMB. As offshore RMB (CNH) will be used for the valuation of RMB denominated Class(es), CNH rate may be at a premium or discount to the exchange rate for onshore RMB (CNY) and there may be significant bid and offer spreads and thus the value of the RMB denominated Class(es) will be subject to fluctuation. Any devaluation of RMB could adversely affect the value of investors’ investments in the RMB denominated Class(es) of certain sub-funds.

Manulife Advanced Fund SPC

Manulife Advanced Fund SPC is an umbrella fund comprising a number of sub-funds investing primarily in equity and bond securities, each of which has a different investment objective and risk level.
The sub-funds do not guarantee distribution of dividends, the frequency of distribution, and the amount/rate of dividends. A sub-fund may at its discretion pay dividend out of capital or gross income while charging / paying all or part of its fees and expenses out of its capital. This amounts to a return or withdrawal of part of an investor’s original investment or from any capital gains attributable to that original investment, and may result in an immediate reduction of the net asset value per share of the respective share classes after the distribution date.
Certain sub-funds with significant exposure to Renminbi (“RMB”) bonds/equity/assets or emerging markets, may involve debt instrument, credit/counterparty, concentration, liquidity, volatility, currency, tax, economic, foreign exchange/multi-currency conversion, down-grading, regulatory and political risks and these risks could be substantially higher than the risks normally associated with the world's more established markets.
A bond sub-fund may hold a significant portion of assets in deposits if there are not sufficient RMB instruments for it to invest in. This may adversely affect its return and performance.
Certain sub-funds using invest directly in debt instruments/shares via QFII regime, the Bond Connect and/or the Foreign Access Regime are subject to various requirements and restrictions under the laws of Mainland China related to investment in QFII and/or China Interbank Bond Market and custodial risks.
RMB is not freely convertible and is subject to exchange controls and restrictions.
Certain sub-funds may have significant concentrated exposures to particular industry sectors and geography's, which subjects investors to concentration and equity market risk.
Certain sub-funds may invest in equities of small- and mid-capitalization companies, which can expose investors to liquidity and volatility risks, and is subject to greater risk than is customarily associated with investments in larger capitalization companies.
Investment involves risk. The sub-funds may expose to a high risk of capital loss. Investors should not invest solely based on this material and should read the offering document for details including the risk factors, charges and features of the sub-funds.

Manulife Hong Kong Series

Manulife Hong Kong Series (“the Series”) is an open-ended unit trust comprising a number of funds primarily investing in equities, debt securities, exchange-traded funds and/or collective investment schemes, each of which has a different investment objective and risk level.
The funds do not guarantee distribution of dividends, the frequency of distribution, and the amount/rate of dividends. Dividends may be paid out of capital and/or out of gross income of certain funds in respect of Inc classes, while charging/paying all or part of certain funds’ fees and expenses to/out of capital of certain funds. This represents a return or a withdrawal of part of an investor's original investment amount or capital gain attributable to that amount. Distributions will result in an immediate decrease in the net asset value of the relevant units. Class AA (RMB) Inc Hedged Unit of certain funds is subject to higher distribution risks than other non-hedged unit classes.
Certain funds may involve equity market, emerging markets, Dim Sum bond market, concentration, volatility, liquidity, credit, credit ratings, below investment grade and unrated securities, credit rating downgrading, interest rates, valuation, sovereign debt, unlisted debt securities, political and regulatory, currency, foreign exchange, derivative and structured product, hedging, and distribution risks. Certain investors may also be subject to the risk relating to RMB hedged share class..
Certain funds are subject to the risks of investing in other funds and the risks relating to asset allocation strategy and/or downside risk management process.
Certain fund is subject to the risks relating to investment in exchange traded funds, Strategic and Tactical Asset Rebalancing Strategy (“STARS”), small- and mid-capped companies, convertible bonds and the risks associated with securitised debt instruments and investments in loss-absorption features. Certain fund is a feeder fund that invests all or substantially all of its assets in another collective investment scheme (the “master fund”) and is therefore subject to the risks of investing in the master fund.
Certain fund will not have direct investments other than cash, cash equivalents and financial derivative instruments (such as futures, options and forwards).
Investment involves risk. The funds may expose its investors to capital loss. Investors should not make investment decisions based on this material alone but should read the offering document for details, including the risk factors, charges and features of the Fund and its unit classes.