Part 1: Global Inflation US stimulus and closing output gaps pose upside risk

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1 Investment Research General Market Conditions 26 February 2018 Part 1: Global Inflation US stimulus and closing output gaps pose upside risk This week, we plan to publish a series of papers on the theme is inflation finally coming and implications for markets? In this first paper, we focus on global inflation. In our base case, we forecast that inflation will rise gradually from very subdued levels. Looking at different factors such as fiscal and monetary policies, output gaps, oil prices and China/emerging market factors, we believe the balance of risks to global inflation relative to our forecasts and market expectations is on the upside. The combination of the significant US fiscal boost at a time when output gaps are closing poses upside risks to global inflation, as we do not expect central banks to offset this by tightening monetary policy aggressively. Moreover, risks to oil prices are skewed on the upside, which could have a significant impact on inflation Inflation and markets Part 1: Global inflation, 26 February Part 2: Eurozone inflation, 27 February Part 3: Scandi inflation, 28 February Part 4: FI implications, 1 March Part5: FX implications, 2 March Moreover, the advanced stage of the business cycle in many emerging markets and higher commodity prices imply that emerging market inflation is likely to rise over coming years. However, we believe the reflationary force from China seen in 2017 is likely to ease as credit tightens and the housing market slows. In addition, different indicators suggest that global monetary policy is turning neither more nor less accommodative. In sum, we see the balance of risk to global inflation skewed to the upside, particularly in 2019, as fiscal expansion and closing output gaps should drive higher core inflation. Market pricing what has changed? Markets have been pricing higher inflation since June 2017 supported by rising global growth expectations. (See Chart 1). In the US, market-based measures of inflation expectations have risen sharply since mid-december. (Chart 2, next page). The trigger for the rise in US inflation expectations appeared to have been the approval of the US tax reform in December 2017 and the spending deal in early February. In the Eurozone, breakeven inflation has also risen since June 2017 but the rise has been limited since mid- December. (Chart 3). This suggests that specific US factors are at play. Table 1: Upside risks to our inflation forecasts Output gap Fiscal policy Monetary policy Oil prices China factors EM ex. China factors Total Table 2: Market pricing is below even our conservative base case scenario DB CPI forecasts, market pricing in bracket US CPI 2,2 2.5 (2.4) 2.1 (2.0) Euro area HICP 1,5 1.4 (1.3) 1.3 (1.3) UK CPI 2,6 2,2 1,8 Japan Core CPI 0,4 0,6 1,0 China CPI 2,0 2,3 2,3 Special issue on 27 February: The Remarkable Decline in Emerging Market inflation: Facts and investment implications Global Head of FICC Research Thomas Harr, PhD thhar@danskebank.dk Head of International Macro and EM Research Jakob Ekholdt Christensen jakc@danskebank.dk Senior Analyst Mikael Olai Milhøj milh@danskebank.dk Chief Analyst Allan Von Mehren alvo@danskebank.dk Senior Analyst Jens Nærvig Pedersen jenpe@danskebank.dk Senior Analyst Vladimir Miklashevsky vlmi@danskebank.dk Source: Danske Bank Source: Danske Bank Important disclosures and certifications are contained from page 9 of this report.

2 Output gaps are closing First, let us take a steep back. Are the pre-conditions for an increase in inflation in place, i.e. have capacity utilisation and labour markets tightened enough to drive inflationary pressures? Below we provide estimates of the output gaps in the advanced and emerging economies (Chart 4). Given our expectations of continued economic growth, the global output gap is likely to turn increasingly positive over coming years. The positive global output gap is an upside risk for inflation in coming years. Chart 4. The global output gap is set to turn increasingly positive over coming years Chart 1. Growth expectations have risen sharply Current Bloomberg consensus GDP forecasts 3,5 3,0 2,5 2,0 1,5 1,0 Japan Italy Germany France UK USA 0,5 0,0 0,0 0,5 1,0 1,5 2,0 2,5 3,0 3,5 Bloomberg consensus GDP forecasts 6M ago Note: The size of the circles reflects the size of the economies measured in USD bn. Source: Bloomberg, Danske Bank Note: Data are based on IMF and OECD output gaps for advanced economies (AE). For emerging markets (except for China), we use the deviation of the actual unemployment rate from a long-term unemployment rate. For China, we use M1 to derive a measure for the output gap. The emerging markets included in the measure are Brazil, Chile, China, Czech Republic, Hungary, Indonesia, Malaysia, Mexico, Poland, Russia, South Korea and Thailand; while advanced economies include the US, UK, Australia, Canada, Japan, Germany, France, Spain, Italy and the Netherlands. The AE, emerging market and global measures of the output gaps are based on a weighted average of the sizes of the individual countries measured in PPP Source: IMF WEO October 2017 and Danske Bank However, although a positive output gap is associated with rising wage pressure, the ultimate impact on inflation also depends on the development of productivity growth. If productivity growth rises along with higher wage growth, then it should not give rise to higher inflation. The recent recovery in global investment growth could very well spur a rise in productivity growth in coming years, which would dampen the inflationary impact from higher wage growth. Nevertheless, the central banks tend to focus mostly on the development in labour costs and signs that the Philips curve is steepening. They comment much less on productivity and unit labour cost. Thus, we expect central banks and markets to react mostly to the development in actual wage growth (rather than unit labour cost) as a guide for future inflation pressures. Fiscal policies are turning more expansionary The development of output gaps is affected by economic policies, in particular fiscal and monetary policies. In general, we believe fiscal policies in advanced economies will turn increasingly expansionary over the next two years, led by the US. The US government has embarked on a major fiscal easing, amounting to almost 2% of GDP through to end In our view, the recent rise in spending ceilings following the tax cuts in December means the fiscal deficit will increase to around 5.2% of GDP in 2019, from 3.5% of GDP in Given the economy is already operating close to full capacity; the easing is likely to ignite inflationary pressures unless it is countered by a more hawkish Fed. So far, this does not seem to be the case, although we do not yet know how the Fed is reacting to the spending deal. Chart 2. US breakeven inflation has risen sharply since mid-december % US breakeven inflation Year Source: Bloomberg, Danske Bank Chart 3. Eurozone breakeven has only risen very modestly recently % Germany breakeven inflation Source: Bloomberg, Danske Bank 23/02/ /12/ /06/ /02/ /12/ /06/ Year 2 26 February

3 In the Eurozone, there is uncertainty about the fiscal policies of the incoming governments in Italy and Germany. In Germany, the SPD/CDU/CSU blueprint expects a combination of a moderate increase in infrastructure spending and lower social security contributions. However, the fiscal loosening is modest in size and spread out over , meaning that the fiscal stance is moderately expansionary at around 0.5pp of GDP in the next two years alone. In our view, a new Italian government is likely to pursue a moderately expansionary fiscal policy. Although the outcome of the Italian election is uncertain and therefore the composition of the new government is uncertain, all parties are calling for higher spending. However, the actual policies may be more moderate than envisaged, given the tight surveillance that Italy is under vis-à-vis the EU debt and deficit rules. Moreover, in 2018 Italy is likely to envisage tighter fiscal policies as a new government will not be able to change much. The real outlier is Japan, which is consolidating its public finances in view of its large public debt. The government is planning to raise the consumption tax in We expect emerging markets to maintain a relatively neutral to contractionary fiscal stance. The only exception is Brazil, where the government is struggling to pass pension reform aimed at improving fiscal sustainability. However, given the general election coming up in the autumn, the fiscal stance is set to be expansionary this year. On balance, we believe fiscal policies globally will turn more expansionary over coming years due to the size of the US economy and its significant fiscal boost. All else being equal, this poses modest upside risks to global inflationary pressures not least when global output gaps are closing. Table 1. Sizeable US fiscal expansion in Fiscal balance (% of GDP) -3,5-4,1-5,2 In bn USD Fiscal effect (pp of GDP): 0 1,3 0,6 Tax relief 0 0,7 0,6 Higher spending caps 0 0,7 0,0 Note: The numbers for 2017 is IMF WEO October 2017 numbers Source: CBO, BEA and Danske Bank Table 2. Fiscal policy set to turn increasingly pro-cyclical in advanced economies in (change in the structural fiscal primary balance) USA Japan Euro (of which) Germany France Italy UK Emerging Markets China India Russia Brazil Note: The judgement is based on the change of the structural fiscal primary balance found in the IMF WEO update in October 2017, except for (1) the US, where we have recently seen tax reform and an increased spending target, (2) and Italy (only 2019) and Germany, where the likely policies under a new government are taken into account. All numbers are in % of GDP. Source: IMF WEO October 2017, Danske Bank 3 26 February

4 Mixed signals from monetary policy Over the medium term, monetary policy drive inflation. We look at different measures to judge how accommodative global monetary policy is currently. First, we look at global nominal GDP growth relative to policy rates. According to this crude approximation, global monetary policy is currently at the most accommodative level since Q1 11 (see Chart 5). Second, we look at broad money supply growth, which reached a high level in 2016 but has since moderated (see Chart 6). Third, we look at growth of a more narrow liquidity measure. This rose somewhat in 2017 but our own projection for 2018 suggests growth will slow to around zero (see Chart 7). Fourth, we look at the development in market-based inflation expectations on a 5Y5Y horizon. This has risen somewhat over the past couple of months but is still relatively low from an historical perspective (see Chart 8). Finally, we look at estimates for the natural rate of interest relative to real interest rates (see Chart 9). This indicates that global monetary policy has turned less accommodative but it is uncertain how neutral rates have developed recently, with central banks arguing that they have risen as potential growth is increasing. Overall, our five measures indicate a somewhat mixed picture of current global monetary conditions. On some measures (i.e. nominal GDP relative to policy rates and inflation expectations) conditions look easier but the development in broad money supply and our outlook for narrow supply growth challenge this conclusion. In particular, it is worth highlighting that if liquidity stops growing over the course of 2018, which we see as a real possibility, it is likely to have a negative spill over to broad money-supply growth. In contrast, we think it is important to highlight the debate that seems to have started within the Federal Reserve about the possibility of replacing the inflation target with something else, e.g. a price level target. To us, this indicates an increasing awareness within the Federal Reserve of the persistent undershooting of its inflation target in the current situation with a low natural rate of interest and higher probability of another encounter with the zero lower bound over the medium-term horizon. Increased expectations of a change in target means that monetary conditions, at least in the US, could turn more accommodative over the course of 2018 and Overall, monetary policy does not seem to add or remove fuel from the reflation theme. Chart 5. Nominal GDP growth vs policy rates are at the widest level since Q1 11 Chart 6. Turning lower from accommodative levels Note: We weight the broadest money supply measure available using nominal GDP weights for the US, China, the euro area, Japan, the UK, India, Brazil, Australia and Canada; for China we use M1 money supply Source: Macrobond Financial Chart 7. Narrow money growth could turn lower in 2018 Note: We weight the monetary base using nominal GDP weights for the US, China, the euro area, Japan, the UK, India, Brazil, Australia and Canada; we base the projection on our own assumptions for the US and Eurozone and extrapolation of the recent trend for the rest Source: Macrobond Financial Chart 8. Inflation expectations have bottomed out but are still at low levels Note: Global nominal GDP and policy rates are calculated from the US, China, Eurozone, Japan, UK, India, Brazil, Canada and Australia; the weights are calculated by the size of the economy in current prices Source: IMF, Macrobond Financial, Danske Bank Note: We have weighted the 5Y5Y inflation swap for the US, Eurozone, Japan and the UK using nominal GDP measured in USD BN. Source: Macrobond Financial 4 26 February

5 Chart 3: According to the natural rate hypothesis monetary policy is turning less accommodative but there is uncertainty regarding recent changes in natural rates Note: The global natural rate of interest is calculated as the IMF PPP GDP weighted sum of the natural rates in euro area, the US, Canada and the UK; the natural rates are from Laubach-Williams (San Francisco Fed) Source: San Francisco Fed, IMF, national central banks, Macrobond Financial Oil prices pose upside risks to inflation Turning to oil prices, our Brent forecast of USD63/bl in 2018 and USD 65/bl is close to pricing in the oil forward market. However, we see the risk to our forecast mainly on the upside. When assessing the impact of a positive shock to oil prices, it matters whether oil prices rise on the back of stronger demand growth or whether the increase is due to a negative supply shock. The former would go hand in hand with movement in other prices, while the latter would constitute an adverse shock. In 2018, we think it is worth highlighting the risk of a significant negative oil supply shock. For example, tensions between the US and Iran are looming, with President Donald Trump making a push to reinstate nuclear sanctions on Iran. This would restrain Iran s oil exports and push oil prices higher. We see a 10% chance of a permanent rise of 30% in oil prices over a three-month period in 2018, which would send the price of Brent crude from the current level to around USD80/bl. There are other upside risks: a lower USD than we forecast, a further decline in output in Venezuela or Libya, positive demand shocks and so on. A recent comprehensive IMF study (see IMF WP/17/196, Oil Prices and Dynamics: Evidence from Advanced and Developing Economies) found that a 10% increase in oil prices increases on average inflation 0.4 percentage point, with the effect vanishing after two years. Other studies find smaller effects in the area of percentage points, which we believe are more plausible. Therefore, we could expect a percentage point boost to inflation over coming years in case oil prices rise 30%. Importantly, both the Federal Reserve and the ECB are more focused on core inflation measures (the ECB in particular has made a shift in this direction recently), which means we expect both to allow such an oil price shock as the one sketched out above, to pass through to headline inflation and not be overly concerned about second round effects. In the case of the ECB, this also happened in Q1 17. The bottom line is that we see oil prices as a clear upside risk to global inflation in coming years February

6 US inflation set to move gradually higher As mentioned above, the Federal Reserve is more interested in core inflation than headline inflation, which we believe is fair given that core inflation is a better gauge of underlying inflationary pressure in the economy. While higher commodity prices (and the weaker USD) are pushing overall inflation higher, we do not expect second-round effects to push core inflation significantly higher. The US is much more closed than, for example, Europe, most goods imported to the US are already denominated in USD and the pass-through from higher oil prices to non-energy prices is weak, in our view. Looking at the Phillips curve, economists tend to disagree on its slope. Some analysis (such as this Dallas Fed blog post) finds that the Phillips curve is quite flat (parameter -0.07), meaning that a tight labour market would lift inflation only slightly. Papers such as IMF October 2016 find a steeper Phillips curve (coefficient -0.4), which still means that unemployment has to fall 1pp for inflation to move 0.4pp higher. Our own model for the CPI core Phillips curve builds on the principles from the IMF methodology but uses CPI core instead of headline inflation and University of Michigan long-term inflation expectations. We estimate the slope of the Phillips curve to be -0.1, meaning that a 1pp fall in the unemployment rate lifts CPI core inflation by only 0.1pp. Ultimately, domestic factors drive US core inflation, which is, in particular, true for service price inflation, as core services account for 60% of total CPI. While the Fed argues, the tight labour market will soon push up wage growth and hence inflation, we think inflation expectations and inflation inertia (lagged inflation) are two factors that are more important. What the estimations (including our own) usually show is that inflation expectations and lagged inflation are important in determining core inflation. In the long run, long-term expectations anchor inflation but there is also a lot of inertia, meaning low inflation is persistent and it takes time to move back towards the long-run level. While market-based inflation expectations have moved higher, we have not yet seen this in survey-based measures (which is what we include in our model). We think we will eventually. With higher inflation expectations, core inflation is set to move higher but it takes time for it to materialise given the inertia. In other words, we expect core inflation to move higher but, in our view, it is mostly a 2019 story. As we have touched on earlier in this document, the higher US inflation expectations reflect (among other things) a combination of very expansionary fiscal policy and the Fed not offsetting the stimuli one to one. Another way to look at inflation is to look solely at wage growth indicators. Many of these (such as jobs quit rate, jobs plentiful and NFIB compensation plans) have indicated higher wage growth for some years now without this materialising in the actual wage growth numbers. In our view, the usually relationship may not hold anymore due to a combination of lower productivity growth and lower inflation expectations. Now inflation expectations have moved higher, there is a stronger case for wage growth to move gradually higher, meaning the higher inflation expectations may become self-fulfilling. Looking at balance of risk, indicators show upside risk to this baseline. However, we think one should be cautious, as slack indicators show there is still slack left. Looking at the annual growth in average hourly earnings, it is mainly supervisors (18%) who are experiencing very high wage growth (5.0%) while wage growth among non-supervisory workers (82%) is more modest (2.4%). Also around 15% of Americans are experiencing zero wage growth now, higher than during the expansion before the crisis (11%). Other slack indicators also suggest there is still some slack left in the labour market despite the low level of the headline unemployment rate. Chart 4. US is not a very open economy Source: BEA, Eurostat, Macrobond Financial Chart 5. Our Phillips curve models show the importance of inflation expectations and inflation inertia Model: CPI core inflation as a function of surveybased inflation expectations, lagged CPI core inflation (four-quarter moving average, the unemployment rate gap and import prices) Source: BEA, BLS, CBO, IMF, Danske Bank, Macrobond Financial Chart 6. Survey-based inflation expectations have not moved higher yet Source: Michigan, Bloomberg, Macrobond Financial Chart 7. Many of the usual suspects indicate higher wage growth Source: JOLTS; BLS, Macrobond Financial 6 26 February

7 Reflationary force from China is easing What about the biggest driver of global growth, China? Over the past two years, China has moved from a big deflationary force to a reflationary force, which added to the global rise in inflation. It has been visible, not least, in the rise in Chinese producer price inflation, which swung from deeply negative territory in 2015 to a 7.5% gain at the peak in Two main forces drove the shift: (1) a recovery in the housing market led to stronger activity in the construction sector and thus higher demand for commodities and (2) a fairly big reduction in capacity in, for example, the steel and coal sector 65m tonnes of steel capacity and 290m tonnes of coal capacity were removed in For 2017, the target of closing 50m tonnes of steel capacity was met in August, according to the government. Hence, both stronger demand and lower capacity have been behind the rise in PPI inflation. Looking ahead, we expect the reflationary force to ease somewhat. First, we look for growth to soften as the monetary tightening works its way through the economy and slows down the housing market. We already see signs of a moderate slowdown in Chinese housing, as new home sales were around 10% lower in December compared with the peak in mid-2017 (seasonally adjusted). As the bottom left chart below shows, the credit tightening has been quite severe and has yet to show its full effect on home sales. Second, the capacity cuts are likely to be smaller and hence less reflationary. Within the steel sector, 80% of the planned reduction in capacity from 2016 to 2020 has already taken place. In addition, the mission of the Chinese leadership to lift prices closer to what is seen as market prices has been more or less accomplished. In summary, we expect weaker demand from the Chinese construction sector and fewer supply cuts to lead to stabilisation in metal prices in 2018, following strong increases in Chinese export price inflation already suggests that the inflationary impact of China has peaked. After rising 7% y/y in early 2017, the latest release for December showed a fall to 0.4% y/y. While the decline is feeding quite fast into headline producer prices, it typically works with a lag of three to six months before feeding into core inflation pressures globally. Hence, while reflationary forces are currently pushing up US and euro core inflation, we believe the effect should start to ease in 2018 and into This should work to put a lid on US and euro core inflation pressure and compensate for the upward pressure from other sources, such as tighter labour markets and higher inflation expectations. Chart 8. China PPI inflation to ease further Source: NBS, Bloomberg, Macrobond Financial, Danske Bank Chart 10. Monetary tightening dampens PPI Source: NBS, Macrobond Financial Chart 9. Lower Chinese export price inflation Source: Macrobond Financial Chart 11. Chinese credit tightening set to slow housing further Chart 12. Weaker Chinese home sales Source: NBS, Bloomberg, Macrobond Financial, Danske Bank Source: NBS, Bloomberg, Danske Bank 7 26 February

8 Global inflation Imported inflation from emerging markets to remain low Over the past two decades, emerging markets have seen a remarkable decline in inflation. In 2017, it touched a historical low at 3.1%, marking the smallest differential relative to advanced economies. The tight monetary policy in most countries has driven the fall in emerging market inflation in most countries, as these countries have adopted inflation targeting and granted increasing independence to its central banks. While the business cycle is entering a more advanced stage in many emerging markets (notably in CEE economies) and commodity prices are increasing, we believe there will be upward pressure on inflation in emerging market. However, we still expect emerging market inflation to remain relatively low and accelerate only modestly due to more rigorous monetary policy implementation as mentioned above, anchoring inflation expectations, and a modest increase in real wages due to improving fiscal discipline in emerging markets. Chart 13. Emerging market inflation has fallen to a record low Source: Bloomberg, Macrobond and Danske Bank Chart 14. There has been a substantial structural decline in EM inflation in recent years Pct. Inflation rate at adoption date 2017 end-of-year inflation Source: IMF Survey, 2017, Inflation Targeting: Holding the Line, Danske Bank, Macrobond Financials 8 26 February

9 Disclosures This research report has been prepared by Danske Bank A/S ( Danske Bank ). The authors of this research report are Thomas Harr (Global Head of FICC Research), Jakob Ekholdt Christensen (Head of International Macro and EM Research), Mikael Olai Milhøj, Senior Analyst, Allan Von Mehren, Chief Analyst, Jens Nærvig Pedersen, Senior Analyst and Vladimir Miklashevsky, Senior Analyst. Analyst certification Each research analyst responsible for the content of this research report certifies that the views expressed in the research report accurately reflect the research analyst s personal view about the financial instruments and issuers covered by the research report. Each responsible research analyst further certifies that no part of the compensation of the research analyst was, is or will be, directly or indirectly, related to the specific recommendations expressed in the research report. Regulation Danske Bank is authorised and subject to regulation by the Danish Financial Supervisory Authority and is subject to the rules and regulation of the relevant regulators in all other jurisdictions where it conducts business. Danske Bank is subject to limited regulation by the Financial Conduct Authority and the Prudential Regulation Authority (UK). Details on the extent of the regulation by the Financial Conduct Authority and the Prudential Regulation Authority are available from Danske Bank on request. Danske Bank s research reports are prepared in accordance with the recommendations of the Danish Securities Dealers Association. Conflicts of interest Danske Bank has established procedures to prevent conflicts of interest and to ensure the provision of high-quality research based on research objectivity and independence. These procedures are documented in Danske Bank s research policies. Employees within Danske Bank s Research Departments have been instructed that any request that might impair the objectivity and independence of research shall be referred to Research Management and the Compliance Department. Danske Bank s Research Departments are organised independently from, and do not report to, other business areas within Danske Bank. Research analysts are remunerated in part based on the overall profitability of Danske Bank, which includes investment banking revenues, but do not receive bonuses or other remuneration linked to specific corporate finance or debt capital transactions. Financial models and/or methodology used in this research report Calculations and presentations in this research report are based on standard econometric tools and methodology as well as publicly available statistics for each individual security, issuer and/or country. Documentation can be obtained from the authors on request. Risk warning Major risks connected with recommendations or opinions in this research report, including as sensitivity analysis of relevant assumptions, are stated throughout the text. Expected updates None. Date of first publication See the front page of this research report for the date of first publication. General disclaimer This research report has been prepared by Danske Bank (a division of Danske Bank A/S). It is provided for informational purposes only. It does not constitute or form part of, and shall under no circumstances be considered as, an offer to sell or a solicitation of an offer to purchase or sell any relevant financial instruments (i.e. financial instruments mentioned herein or other financial instruments of any issuer mentioned herein and/or options, warrants, rights or other interests with respect to any such financial instruments) ( Relevant Financial Instruments ). The research report has been prepared independently and solely on the basis of publicly available information that Danske Bank considers to be reliable. While reasonable care has been taken to ensure that its contents are not untrue or misleading, no representation is made as to its accuracy or completeness and Danske Bank, its affiliates and subsidiaries accept no liability whatsoever for any direct or consequential loss, including without limitation any loss of profits, arising from reliance on this research report. The opinions expressed herein are the opinions of the research analysts responsible for the research report and reflect their judgement as of the date hereof. These opinions are subject to change and Danske Bank does not undertake to notify any recipient of this research report of any such change nor of any other changes related to the information provided herein. This research report is not intended for, and may not be redistributed to, retail customers in the United Kingdom or the United States. This research report is protected by copyright and is intended solely for the designated addressee. It may not be reproduced or distributed, in whole or in part, by any recipient for any purpose without Danske Bank s prior written consent February

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