Global Inflation Set to surprise on the upside lifting long-dated inflation pricing Pernille Bomholdt Henneberg Mikael Olai Milhøj Senior Analyst, Euro area macro research Senior Analyst, US and UK macro research +45 45 13 20 21/+44 20 7410 8157 +45 45 12 76 07 perni@danskebank.com milh@danskebank.dk 27 October 2016 Investment Research www.danskemarketsequities.com Important disclosures and certifications are contained from page 19 of this report.
Global inflation to surprise on the upside lifting long-dated pricing Global inflation is going to pick up due to the recent rise in commodity prices. We expect this to reduce the deflation scare further, thereby supporting the market pricing of inflation. In the euro area we expect inflation to reach 1.5% early next year, which will be the highest rate since mid-2013. However, the higher inflation is going to be temporary as it is set to be driven by energy prices, whereas core inflation is likely to remain subdued. In the UK, both headline and core inflation are likely to rise considerably, especially due to the significant depreciation of the GBP. The weaker GBP implies higher import, food and energy prices. In the US, we expect CPI headline inflation to stabilise around 2% next year due to the higher energy prices. CPI core inflation is not expected to move significantly higher as wage growth remains subdued. Chinese deflationary pressures are also easing. We look for a further increase in PPI inflation in coming months as it is being driven mainly by industrial commodity prices and we expect these to continue to trend higher on the back of the recovery in Chinese construction. In Japan inflation has always been far away from Bank of Japan s target. BoJ s new target should not change expectations much as it is not spelled out how to achieve higher inflation. 1
Higher global inflation even if the oil price remains unchanged Global reflation on higher commodity prices The recent rise in commodity prices is going to lift global inflation near term as the drag from the past oil price decline in particular fades. We expect higher global inflation to reduce the deflation scare further, which should affect the market pricing of inflation. Commodity prices vital for global inflation Our forecast is for higher commodity prices, but even if we assume an unchanged oil price it indicates that global G3 inflation could rise towards 2.0% from the current level of 0.4% and up from the deflation limit of 0.0% in end-2015. In the chart on the right hand side, we have made a very simple model for global inflation, which only depends on the oil price. It shows that the oil price is very important when looking at the development of global inflation. Source: Bloomberg, Macrobond Financial, Danske Bank Markets 2
Euro area inflation to increase sharply above the market pricing Euro inflation set to continue to rise sharply For a long time we have argued that euro area inflation will rise sharply at the end of the year and the market has also started to price higher near-term inflation, but longerdated inflation is still priced very subdued. Higher euro inflation as energy drag fades The higher near-term inflation should follow as the drag from the oil price decline fades. Currently energy price inflation drags down headline inflation by 0.3pp, but if the oil price and the energy price stay unchanged, energy prices are set to make a positive impact on inflation of 0.3pp in early 2017. In our base case of a slightly higher oil price, inflation should reach 1.5% in February. Headline inflation will thus be up by more than 1.0pp from +0.4% in September and 2.0pp from the bottom at -0.6% in January 2015 when energy had a drag of 1.0pp. Source: Eurostat, Danske Bank Markets 3
An unchanged oil price scenario also points to higher inflation Our base case is a higher oil price but energy drag will also fade if oil is stable Source: Bloomberg, Eurostat, Danske Bank Markets Source: Eurostat, Danske Bank Markets 4
Risk of upside inflation surprises is underpriced in our view Our 2017 forecast is much above the pricing 2.00% The market is pricing an unchanged oil price 75 bp 75 bp 50 50 1.50% Inflation market pricing is still below our forecast in 2017 25 0-25 25 0-25 1.00% -50-50 0.50% Aug-17 0.95% -75-75 75 bp 75 bp 0.00% 50 50-0.50% Oct-16 0.46% 25 0-25 25 0-25 -1.00% Dec-13 Dec-14 Dec-15 Dec-16 Dec-17 Dec-18 HICP inflation Danske forecast Market pricing Scenario: unchg oil -50-75 -50-75 Source: Bloomberg, Eurostat, Danske Bank Markets Base: Oil rebounds, Q4 2016:USD58/bbl SCEN 1: Oil unchanged:around USD50/bbl SCEN 2: Oil down:below USD25/bbl ECB's inflation projection (September) Source: Bloomberg, ECB, Eurostat, Danske Bank Markets 5
Long-term euro inflation pricing is affected by spot inflation Long-dated inflation lifted by global reflation Higher euro inflation will in our view affect the entire inflation curve (also longer tenors). Historically, spot inflation has driven the entire inflation curve and as illustrated on the right hand side even 10Y10Y inflation expectations are likely to go higher if actual inflation increases sharply. Particularly in a situation where a global reflation theme re-emerges we expect the long-end of the inflation curve to be affected by spot inflation. This should follow, as long dated inflation in our view is currently low due to a negative risk premium on inflation, which is likely to fade in case of higher global inflation. Spot inflation affects 10Y10Y inflation swap Source: Bloomberg, Eurostat, Danske Bank Markets 6
Particularly, the long-end of the inflation curve is priced very low The entire inflation curve is priced very low 2.50 % The inflation curve is driven by spot inflation 2.00 1.50 1.00 3.00 2.50 2.23 2.39 0.50 0.00-0.50-1.00 2.00 1.50 1.00 0.50 0.00 1.56 1.23 0.94 0.82 1.78 1.45 1.60 1.24 0.62 0.28 1y 1y 2y 2y 5y 5y 10y 10y 0y 5y 10y 15y 20y 25y 30y 35y 40y 45y 50y Current Average since 2014 Max/min since 2014 Source: Bloomberg, ECB, Eurostat, Danske Bank Markets Source: Bloomberg, Danske Bank Markets 7
ECB will not react to a temporary blip in inflation No ECB QE tapering despite higher inflation A rise in inflation driven by a higher oil price will not result in the ECB tapering its QE purchases. This was very clear last week, when President Draghi said we will look through blips that are caused by other factors, when asked to be explain what defined a sustained path towards price stability, see speech. Higher inflation expectations will of course be welcomed by the ECB and support the hawkish members view that more easing is not necessarily needed. However, for Draghi and a majority of the ECB members this will only be one step in the right direction and in our view it will maintain an accommodative monetary policy until it sees a convincing upward trend in underlying inflation. No convincing upward trend in core inflation Source: ECB, Eurostat, Danske Bank Markets 8
UK inflation to rise above 2.0% the weaker GBP is supportive Both higher headline and core inflation in UK In the UK, both headline and core inflation are likely to rise significantly bringing headline inflation above 2.0% in the beginning of 2017. This should follow as the drag from both energy and food prices fades and as the weaker GBP supports core inflation through higher import prices. UK CPI inflation already increased to 1.0% in September from 0.6% in August and from deflation of -0.1% in October 2015. The drag from energy prices was zero in September and if the oil price remains unchanged it will have a positive contribution of 0.32pp in February next year. UK inflation to continue rising sharply Source: Macrobond Financial, Danske Bank Markets 9
Significant GBP depreciation to push up import prices Weaker GBP implies higher import prices Higher inflation is reflected in expectations Source: Bloomberg, Macrobond Financial, Danske Bank Markets Source: Bloomberg, Macrobond Financial, Danske Bank Markets 10
Weaker GBP also pushes up food and energy prices Food deflation to end due to weaker GBP Oil price has increased more in GBP terms Source: Bloomberg, Macrobond Financial, Danske Bank Markets Source: Bloomberg, Macrobond Financial, Danske Bank Markets 11
BoE to see through higher inflation BoE will maintain easy monetary policy: On several occasions, the BoE has communicated that it accepts inflation will increase above the 2% target in the coming years to support the economy through the Brexit-negotiations. We still think it is more likely that the BoE will ease further than that it will tighten monetary policy. Actually we expect a BoE rate cut in February 2017 as we see a risk that business confidence and hence growth may take a hit from PM May s harsh stance on Brexit. In our view, the BoE s easing bias will also be supportive for long-term inflation expectations in the UK. Inflation to overshoot 2% target Source: ONS, BoE, Danske Bank Markets 12
US CPI inflation to stabilise above 2.0% US CPI inflation to remain above 2.0% US core CPI inflation not far from 2.0% US CPI inflation increased to 1.5% in September from a bottom at 0.2% in April 2015 with CPI core inflation at 2.2% up from 1.6% in end-2014. Looking ahead, headline inflation is set to rise further as the headwind from the oil price decline turns into a temporary tailwind. Core inflation is not expected to move significantly higher as wage growth remains subdued. In a scenario where the oil price and the US energy price index remain unchanged at the current levels, the headline inflation rate will increase to 2.2% in February given our food and core inflation projections. Source: Bloomberg, Macrobond Financial, Danske Bank Markets 13
Fed to tighten monetary policy only slowly New Fed thinking could support inflation exp.: While we think it is a close call whether or not the Fed will hike at the December meeting, we think it will hike rates only slowly as wage growth is subdued, core inflation is below the 2% target and there is still more slack left in the labour market. Recently, more FOMC members including Fed chair Janet Yellen have expressed the idea of remaining accommodative and letting core inflation overshoot the 2% target, which the Fed has missed for many years. As the Fed turns more dovish next year due to shifts in voting rights, this could be supportive for long-term inflation expectations. FOMC members have expressed the idea to let core inflation overshoot the 2% target Source: BEA, Federal Reserve 14
Euro area and US inflation expectations have not yet recovered Euro and US inflation expectations set to rise The market is still pricing low medium-term inflation in the US and euro area, whereas the pricing in the UK has been supported by the weaker GBP. Euro and US inflation pricing is still very low Looking ahead we expect the higher global inflation to lift the pricing in the US and the euro area, particularly in longer tenors where the negative risk premium on inflation should fade under reduced fear of deflation. That said, core inflation should not move significantly higher implying both central banks should maintain a fairly dovish stance. In the UK, the rising headline and core inflation should continue to be supportive for the pricing of medium-term inflation. Source: Bloomberg, Macrobond, Danske Bank Markets 15
Base effects will be stronger in the US than in UK and euro area Our base case is a higher oil price but energy drag will also fade if oil is stable Source: Bloomberg, Macrobond Financial, Danske Bank Markets Source: Bloomberg, Macrobond Financial, Danske Bank Markets 16
Chinese PPI out of deflation territory for the first time since 2012 Chinese PPI inflation on a solid upward trend Higher inflation is also seen in China, where CPI inflation reached 1.9% y/y in September from 1.3% y/y in August and a bottom in early 2015 at 0.6% y/y, see China: deflationary pressures keep easing, 14 October. Positive Chinese PPI inflation Chinese PPI inflation has also recovered in line with the higher metal prices and in September it turned positive at 0.1% y/y from -0.8% y/y in August and up from the very low -6.0% in end-2015. In coming months we look for a further increase in PPI inflation as it is being driven mainly by industrial commodity prices and we expect these to continue to trend higher on the back of the recovery in Chinese construction. Source: Bloomberg, Macrobond, Danske Bank Markets 17
New Japanese inflation target not enough to lift expectations New inflation target does not change much In Japan, inflation has always been far from reaching Bank of Japan s (BoJ) 2.0% inflation target and the newly introduced target of inflation overshooting 2.0% has not changed the market perception that Japanese inflation will stay very low. Japanese inflation has always been very low In our view, the problem with BoJ s new inflation target is that BoJ has not spelled out how it is going to achieve a higher inflation rate. To reach inflation above 2%, we believe, Japan needs a commitment to a permanent increase in the money supply, i.e. monetisation of the government debt (alongside structural reforms to lift the potential growth rate). Source: Macrobond Financial, Danske Bank Markets 18
Disclosures This research report has been prepared by Danske Bank Markets, a division of Danske Bank A/S ( Danske Bank ). The author of this research report is Pernille Bomholdt Henneberg, Senior Analyst. Analyst certification Each research analyst responsible for the content of this research report certifies that the views expressed in this 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. The research reports of Danske Bank are prepared in accordance with the Danish Finance Society s rules of ethics and 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 a sensitivity analysis of relevant assumptions, are stated throughout the text. Date of first publication See the front page of this research report for the date of first publication. 19
General disclaimer This research has been prepared by Danske Bank Markets (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 in this research report. 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. Disclaimer related to distribution in the United States This research report was created by Danske Bank A/S and is distributed in the United States by Danske Markets Inc., a U.S. registered broker-dealer and subsidiary of Danske Bank A/S, pursuant to SEC Rule 15a-6 and related interpretations issued by the U.S. Securities and Exchange Commission. The research report is intended for distribution in the United States solely to U.S. institutional investors as defined in SEC Rule 15a-6. Danske Markets Inc. accepts responsibility for this research report in connection with distribution in the United States solely to U.S. institutional investors. Danske Bank is not subject to U.S. rules with regard to the preparation of research reports and the independence of research analysts. In addition, the research analysts of Danske Bank who have prepared this research report are not registered or qualified as research analysts with the NYSE or FINRA but satisfy the applicable requirements of a non-u.s. jurisdiction. Any U.S. investor recipient of this research report who wishes to purchase or sell any Relevant Financial Instrument may do so only by contacting Danske Markets Inc. directly and should be aware that investing in non-u.s. financial instruments may entail certain risks. Financial instruments of non-u.s. issuers may not be registered with the U.S. Securities and Exchange Commission and may not be subject to the reporting and auditing standards of the U.S. Securities and Exchange Commission. 20