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Inflation, interest rates and asset prices in a transition phase

There are several factors that have led to a sweet spot for financial markets (low inflation, loose monetary policy and the economic recovery) in recent years. However, these factors are now declining in force and will disappear or turn to negative.

Firstly, reserve capacity is increasingly on the wane worldwide and in some major economies such as Japan, the US and Germany the situation is already tight, especially on the labour market. This will lead to loose monetary conditions, higher wage incomes and increased investment, resulting in economic growth being above potential in most countries in our opinion. Subsequently, the reserve capacity will continue to decline and the tightness on the labour market will increase. Because of this we anticipate higher levels of wage increases in the quarters ahead and therefore upward pressure on inflation expectations. In this scenario, we see many central banks accelerating the pace at which they make monetary policy less loose.

Secondly, we expect additional wage increases to lead to higher wage costs and, due to fierce competition of, among others, internet businesses, we see many businesses allowing higher wage costs to come at the expense of profit margins.

Thirdly, an important congress of the Communist Party of China took place in October, (this Market View was written before the congress) where President Xi was awarded a second term. In the run up to the congress, the Chinese authorities are making every effort to ensure the greatest possible financial and economic stability, meaning the authorities will not seriously tackle the unstoppable rise in debt/GDP ratios until afterwards. Putting the brake on credit provision means downward pressure on growth. As China is the second largest economy in the world and is responsible for the largest contribution to global economic growth, this also means downward pressure on growth worldwide.

Fourthly, in recent years the US and Europe in particular have benefited from:

  • Lower interest rates, which have enabled governments, businesses and consumers to borrow more without rising interest charges (or only to a limited degree).

  • Pent-up demand, because businesses and consumers postponed major expenditure during the credit crunch, although it must be noted that expenditure has increased in recent years.

Stimulus as a result of pent-up demand and more debt does not necessarily have to stop immediately, but we do see its positive effect on growth decreasing, certainly if interest rates start going up in the period ahead.

Chart 1: An ageing population and rising government debt pose a serious economic threat
Chart 1: An ageing population and rising government debt pose a serious economic threat

Source: Forecast of Oxford Economics
Source: Thomson Reuters Datastream/ECR Research

Positive supply shock

Finally, the post-1980 positive supply shock, as a result of China and the former Communists European countries opening up to the world economy, threatens to slowly turn now due to a rapidly ageing population in many Asian and European countries. In most developed economies (including China) the number of working people in relation to the number of pensioners will decrease greatly in the decades ahead if policy remains unchanged. Not only does this mean there will be relatively fewer people creating output, but also that more and more people will use their savings for consumption. At some point, this will contribute to increasing upward pressure on wage increases and inflation and result in less (pension) money requiring investment.

Consequently, we see persistent downward pressure on inflation and long-term interest rates gradually turning to persistent upward pressure, and we envisage share prices coming under mounting downward pressure. It will also have a significant impact on economic expectations and monetary policy. In the event of rising interest rates, soaring debts will weigh more heavily and refinancing risks will increase. Furthermore, with rising inflation and interest rates it will become more difficult for central banks to boost asset prices and growth.

Transition phase for financial markets

Because we foresee a reduction in force or even the complete disappearance of the factors that have created a very favourable backdrop for financial markets in recent years, we anticipate investors becoming increasingly concerned about the high valuations and the consequences of low potential growth, a less loose monetary policy and the excessively high debts.

We do not see this leading immediately to a considerable decline for asset prices or much higher borrowing costs. Some of the aforementioned developments are progressing slowly and will therefore not have a major impact on the markets over the next months or perhaps quarters. Furthermore, we foresee several developments over the next couple of months which are positive for asset prices:

  • We consider the option of tax cuts in the US.

  • Due to the tighter labour market in countries such as the US, Germany and Japan, we anticipate businesses stepping up investment. As a result, we anticipate a boost in hopes for a positive scenario as previously described in this article.

  • We envisage that additional wage increases and consequently higher inflation expectations and a less loose monetary policy will initially be regarded as a confirmation that the economy is recovering sustainably. This might even additionally boost confidence among consumers and businesses.

  • We foresee the ECB and the Bank of Japan keeping monetary policy very loose for the time being, thereby offsetting the effect of a less loose monetary policy in the US, for example. It has been evident over the last quarters that Fed rate hikes have not led to tighter monetary conditions in the US. The reason may be that investors assume the Fed is pursuing too tight a policy at present. As a result growth will ultimately be slowed down too much and the Fed will have to climb down again. Hence US long-term interest rates remained under downward pressure and the dollar has weakened. But it is also down to the ultra-low interest rates in Japan and Europe, which create downward pressure on US long-term interest rates as well.

Although the positive climate for stock prices might continue, we do expect upward pressure on long-term interest rates because of the expanding economy, tighter monetary policy and upward pressure on inflation expectations. Initially, long-term rates could increase gradually, followed by a stronger increase as we expect investors will realise that higher borrowing costs will make high debt levels much harder to service, prompting many central banks to pursue a too loose monetary policy, with higher inflation as a consequence.

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