There are two main drivers of asset class returns – growth and inflation.
- Ray Dalio

Some jerk (meant in the friendliest possible way) asked me a while ago: “Why do economists provide estimates of inflation to the nearest tenth of a percent?”. I thought for a second, but before I got a chance to answer him, he said: “To prove they have a sense of humour.”

In fairness to this ‘awful’ friend of mine, 99.9% of all economists got it completely wrong in the years following the financial crisis. Nearly everyone thought QE could only end in runaway inflation, but what happened? With only a limited number of exceptions, all over the world, inflation continued to go lower and lower. Until the second half of 2016 the number of inflation die-hards continued to shrink, but then it all changed. The inflation bulls began to come out of their retreats again after years of hiding in shame (exhibit 1).

Exhibit 1: Option-implied probability of 5-year US inflation
Exhibit 1: Option-implied probability of 5-year US inflation. Note that low is less than 1%; medium is 1-3%, and high is in excess of 3% inflation.
Source: The Daily Shot, Bloomberg, Goldman Sachs Global Investment Research, February 2017.

As you can see from the lower right corner of exhibit 1, the number of inflation bears has dropped quite dramatically in recent months. As we entered 2016, approx. 40% thought there would hardly be any inflation when looking five years out. That number has since declined to less than 10%.

As you can also see, whilst the number of inflation bulls have increased over 2016, they still only account for 20%. However, a much larger percentage (now about 70%) subscribe to the sweet spot outlook – a rather benign inflation environment of 2% +/-. This range is typically viewed as constructive for economic growth and for equity prices, both of which tend to do best, when inflation trades in the range of 1.5-2.5%.

It is therefore not too difficult to see why equities continue to perform quite well despite some very dark clouds gathering in the horizon. If you wonder what those clouds are, I suggest you go back to the January Absolute Return Letter.

This raises the critical question: Should I, having been a long-term bear on inflation, change tact? Could the inflation bulls finally be right? There is no straightforward answer to that question, as different parts of the world are subject to very different dynamics, but I will certainly give it a try.

Are central banks worried about inflation?

Central bankers are known for their glass-is-half-empty approach to things, so one should be careful not to over-interpret statements from that corner, but inflation seems to be back on the agenda at the moment. You will probably immediately push back and say they should worry about inflation; that is why they are there in the first place. Correct, but inflation has taken up an inordinate amount of space in recent minutes from various central bank meetings (exhibit 2).

Exhibit 2: Mention of inflation in proportion of paragraphs in recent BoE, Fed and ECB minutes
Exhibit 2: Mention of inflation in proportion of paragraphs in recent BoE, Fed and ECB minutes
Source: The Daily Shot, Goldman Sachs Global Investment Research, February 2017