Global Multi-Asset Viewpoint Reports of Inflation s Death Have Been Greatly Exaggerated

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1 Global Multi-Asset Viewpoint Reports of Inflation s Death Have Been Greatly Exaggerated SOLUTIONS & MULTI-ASSET GLOBAL MULTI-ASSET TEAM MACRO INSIGHT AUGUST 2017 The biggest surprise of 2017 thus far for the global economy has been that not only did global growth need to be revised UP for the first time in seven years, but that simultaneously inflation needed to be again revised down, particularly in the U.S. The U.S. bond market initially focused on the improving growth outlook with the 10-year yield hitting three-year highs of 2.62% in March this year. But since then, disappointments in U.S. inflation have caused investors to question and, more recently, emphatically reject the Fed s own guidance (as provided through the dots ) on the path of interest rates. Markets have thus priced out most Fed tightening over the next 2-3 years and, as of today, the next 25 basis point rate hike is only fully priced to occur by December 2019, more than two years from today. This stands in stark contrast to the Fed s own expectations for seven hikes over that time frame (one more in Dec 2017, three in 2018 and three in 2019). Though we expect the Fed will be forced to revise down these aggressive hiking forecasts, our analysis indicates that markets have swung to a far too deflationary mindset. We expect that U.S. 10-year yields will likely increase by at least 40 basis points over the next two quarters, from 2.1% today. 1 Where the Fed expects four hikes before December 2018 and the market expects less than one, we expect three: one this December, one next June and one in December This would result in a Fed Funds rate of 1.875% by end of If this is correct, the U.S. 10-year yield is likely to sell off to 2.5% as this scenario gets priced in. In our view, financial stocks AUTHORS Display 1: Next 25bps Rate Hike Only Fully Priced to Occur in December 2019 Fed Funds Market Pricing vs. FOMC Dots and GMA Forecast Percent (%) Jul-14 Jul-15 Jul-16 Jul-17 Jul-18 Jul-19 Dec-20 Fed Funds GMA Forecast CYRIL MOULLÉ-BERTEAUX Portfolio Manager Head of Global Multi-Asset Team Managing Director SERGEI PARMENOV Portfolio Manager Global Multi-Asset Team Managing Director Market Pricing (OIS) FOMC Jun Dots Forecasts/estimates are based on current market conditions, subject to change, and may not necessarily come to pass. Source: MSIM Global Multi-Asset (GMA) Team analysis; Bloomberg LP; Haver Analytics. Data as of August 31, 2017.

2 MACRO INSIGHT are likely to outperform after giving up two thirds of their post- Trump-election rally (relative to broad U.S. equities). 2 There are three main arguments for expecting three hikes in the Fed funds rate in the next 15 months: 1) With the latest print at 1.4%, core inflation measured by the Personal Consumption Expenditures (PCE) Core Deflator Index is below the Fed s 2.0% target and, this year, has reversed half of its post-financial-crisis increase. 3 However, we expect core PCE inflation to remain at 1.4% at year end, 1.8% by end-2018 and 2.0% by end-of 2019 (2.2% and 2.4% respectively for core CPI). 4 Like the Fed, we view at least 20 basis points of the recent decline as transitory (with most of it driven by a temporary unlimited data plan offered by Verizon, which caused a 15% decline in telecom consumer prices in March), which means the current underlying inflation rate is likely actually 1.6%. 5 Display 2: U.S. Core Inflation to Resume Gradual Climb to 2% U.S. Core PCE Deflator and FRB Dallas Trimmed Mean PCE Inflation Rate with GMA Team Forecasts Percent (%) bps of recent decline mostly driven by telecom consumer prices FRB Dallas Trimmed Mean PCE Inflation Rate U.S. Core PCE Deflator, Yoy, 3mma GMA Team Forecast Forecasts/estimates are based on current market conditions, subject to change, and may not necessarily come to pass. Source: MSIM Global Multi-Asset (GMA) Team analysis; U.S. Federal Reserve Board; Haver Analytics. Data as of August 31, We expect underlying inflation to rise by 20 basis points per year for the next two years, driven by higher wages and the end of the strong-dollar-driven headwind to imported prices. With growth yet again above trend for the ninth year, unemployment keeps falling and will likely hit 3.6% by the end of Our analysis, as well as academic and sell-side research, strongly confirms the continued existence of a Phillips curve trade-off between wages and unemployment, after taking into account the current regime of low productivity, lower inflation expectations, and hidden slack. Every 1% decline in the unemployment rate leads to an 80 basis points increase in wages, based on our analysis. Given low productivity, Unit Labor Costs (wages adjusted for productivity) should hit 2.5% in 18 months. This should continue to drive inflation higher albeit at a very modest pace. With inflation approaching its target, the Fed is likely to hike more than once over the next 2 ¼ years. 6 2) At 2.1% in the first half, the U.S. economy is continuing to grow at a significantly above-trend pace and, until financial conditions are tightened (see next point), is unlikely to drop below 2%. 7 Assuming trend productivity growth of 0.75% and labor force growth of 0.75%, U.S. potential growth is only 1.5% so the current 2.1% pace is generating 175, ,000 jobs every month. 8 At this pace, we expect unemployment to drop to 4.2% by year end and 3.6% by end That would be a 50 year low in unemployment! It is very hard to imagine the Fed keeping policy rates below inflation with the strongest labor market (and implicitly the strongest economy relative to potential) in fifty years. 3) An additional factor likely to drive the Fed to continue monetary tightening is near-record easy financial conditions. Even though the Fed has raised interest rates four times during this cycle, financial conditions for the U.S. economy have not tightened: corporate borrowing rates are at record lows, the stock market is at a record high and the U.S. Dollar has depreciated by 10% this year. 9 According the Goldman Sachs Financial Conditions Index, financial conditions have eased by the equivalent of over 200 basis points in Fed funds rate decreases in the past eighteen months and are back to where they were in 2014, before the Fed started raising rates in December As the economy approaches full employment and inflation is forecast to hit 2% within the Fed s two year forecast horizon, 11 the Fed is looking to modestly tighten financial conditions back to neutral levels, but this has not occurred due to financial markets offsetting the Fed s policy rate moves. As a result, the Fed is likely to continue to tighten until it sees its monetary policy impacting overall financial conditions (obviously the converse is also true in that an unexpected tightening in financial conditions from a credit or stock market correction might cause the Fed to pause). 4) Lastly, the global context is supportive of the Fed continuing to raise rates. Since the 2013 taper tantrum, Fed tightening has repeatedly been delayed by global growth uncertainties (mostly related to the Eurozone periphery as well as China and emerging markets and those regions impact on the U.S. dollar). But today, almost every region s economic growth is beating expectations; the Eurozone has had the biggest surprise, but Japan and China are also surprising positively MORGAN STANLEY INVESTMENT MANAGEMENT SOLUTIONS & MULTI-ASSET

3 REPORTS OF INFLATION S DEATH HAVE BEEN GREATLY EXAGGERATED More and more countries labor markets are healing and reaching full employment levels (e.g. Japan unemployment is at 25-year lows, Germany at 35-year lows, Canada is within 40 basis points of 42-year lows, even the UK is at 40-year lows). 13 The disinflationary pressures coming from the rest of the world are fading, supporting the Fed s effort to remove monetary accommodation. Display 3: Developed Markets Unemployment Rate Approaching 40-Year Lows Developed Markets Unemployment Rate Percent (%) Note: Developed Markets include 23 countries. Source: MSIM Global Multi-Asset (GMA) Team analysis; Haver Analytics. Data as of August 31, With U.S. inflation slowly trending back towards 2%, the unemployment rate approaching 50-year lows, near-record easy financial conditions, and a strong global economy, it seems to us very likely that the Fed will hike not just once over the next 2 ¼ years, as the market is currently pricing, but more like five times (twice a year). There are clearly risks to this view. We would highlight three, below: 1) We and the Fed expect that a portion of the recent drop in inflation reflects transitory factors. However, some argue that an acceleration of disinflationary forces from technology is responsible. Thus, this recent drop represents a true shift in the trend rate of inflation. It seems unlikely to us that shifts in pricing behavior driven by technology would suddenly appear in a six-month period rather than slowly, over time. In addition, there are some indications that price convergence between off- and on-line has already occurred in the areas most susceptible to online competition. However, it is very hard to prove or disprove the impact of technology on consumer prices. Some also argue that the hidden slack in the labor market is greater than headline figures indicate, thus creating greater disinflationary pressure. We partially agree, and do include an additional 50 basis points of hidden slack on top of the current 4.4% unemployment rate to account for this. 14 But we again find it hard to believe that this hidden slack would be exerting greater disinflationary pressures today (nine years into the expansion) than in prior years. It is also important to note that there is often variability in inflation (as in any economic data) around the underlying trend, so the market may be reading too much into this most recent decline. 2) A second, potentially more severe, risk is related to the potentially unexpected impact of the Fed s planned quantitative tightening (since balance sheet expansion was labeled quantitative easing or QE, we label balance sheet reduction quantitative tightening or QT). Highlighting the differences between expectations and reality as it relates to monetary policy, Former Fed Chair Ben Bernanke once quipped, The problem with QE is it works in practice but it doesn t work in theory. 15 It could also very well be that, despite the Fed attempting to focus the market s attention on rates as the main policy instrument, QT turns out to have an outsized impact on financial markets. We have been of the view that the Fed s single-minded focus on a narrow objective such as 2% inflation, irrespective of financial stability, was likely creating excesses in asset valuations as most assets around the world (e.g. stocks, bonds, real estate, private equity, venture capital); many of these assets appear to be valued at the top end of their historical ranges. Markets have taken interest rate hikes in stride so far, but the shift to QT by the Fed this fall, in addition to the ECB likely tapering in early 2018, will likely mean that the G4 central banks will go from buying over $1 trillion in assets per year in the past two years to selling assets sometime in the next 18 months. 16 This shift in net supply is likely to have an impact on asset prices, and not necessarily the assets one would expect. QE counterintuitively caused bonds to sell off; QT could very well cause bonds to rally but risk assets to decline significantly as the global central banks support for the search for yield and reach for risk fades. Such a market reaction would likely cause the central banks to pause and ultimately abandon balance sheet reductions and interest rate hikes. This would be a significant concern for our view, but likely more of a 2018 issue than 2017 given that the G4 central banks balance sheets will keep growing in the near term. 3) Finally, there is a risk that we are still in a de-leveraging environment in which rates are structurally constrained. Real policy rates have often historically stayed at very low levels sometimes even negative during periods of deleveraging, or when debt growth is very modest. If we are in such an environment, we cannot necessarily assume that the Fed will seek to raise monetary policy rates above SOLUTIONS & MULTI-ASSET MORGAN STANLEY INVESTMENT MANAGEMENT 3

4 MACRO INSIGHT the level of inflation. With debt already at high levels, the Global Financial Crisis still a recent memory, and debt growing at levels marginally higher than GDP growth, 17 the economy has just barely begun to re-leverage. This would imply lower demand for capital, and continued low policy rates and market yields for now. Overall, the markets pricing of only one hike for the next 2 ¼ years vs. the Fed s own forecast of seven hikes has created opportunities with asymmetric risk/return, in our view. If U.S. and global growth is maintained at current levels as we expect for the near future, it is likely that inflation will re-converge with its modest gradual upward trend and that the Fed will resume tightening in December (after a September pause when it announces its plan for balance sheet reduction). In this case, 5- and 10-year Treasuries are likely to see yields rise by 40 basis points at least over the next couple of quarters. This would also benefit other rate sensitive assets, such as banks, which are back to trading at a 33% discount to the market despite prospects for market-like earnings growth and massive return of capital to shareholders (total 5-7% shareholder yields). 1 2 MSIM Global Multi-Asset (GMA) Team analysis. Financial stocks as measured by the S&P 500 Financials Index Sector. U.S. equities as measured by the S&P 500 Index. 3 4 MSIM Global Multi-Asset (GMA) Team analysis. 5 Ibid. 6 Ibid. 7 8 MSIM Global Multi-Asset (GMA) Team analysis; Haver Analytics Ibid. 11 U.S. Federal Reserve Board, Federal Open Market Committee Projections, June MSIM Global Multi-Asset (GMA) Team analysis, Haver Analytics. 13 MSIM Global Multi-Asset (GMA) Team analysis; Haver Analytics; Bloomberg LP. 14 MSIM Global Multi-Asset (GMA) Team analysis; Congressional Budget Office; U.S. Department of Labor. 15 Ben Bernanke; Brookings Institute Central Banking After the Great Recession: Lessons Learned and Challenges Ahead. A Discussion with Federal Reserve Chairman Ben Bernanke in the Fed s 100th Anniversary. January 14, Washington D.C. 16 Bank of England; Bank of Japan; Federal Reserve; European Central Bank; JP Morgan Research. 17 MSIM Global Multi-Asset (GMA) Team analysis; Haver Analytics; Federal Reserve Board. 4 MORGAN STANLEY INVESTMENT MANAGEMENT SOLUTIONS & MULTI-ASSET

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