Central banks remain divided on how to handle inflation

Central banks’ rhetoric continues to be mixed, with policy-makers facing the conundrum of improving economic growth and falling unemployment, but inflation that remains below target. The traditional Philips Curve relationship is widely being called into question, with the impact of technology at the centre of the debate. Policy-makers seem divided in their opinion, some wishing to pre-empt a rise in inflation with tighter policy, others preferring to wait to see if it rears its head.

The US Federal Reserve last month kept interest rates unchanged, although its outlook for rates and inflation was perhaps more hawkish than the market expected. This has been reflected in a small rise in expectations of a December rate increase, now considered a 73 per cent probability. The Fed rate setting committee reiterated its June statement by announcing that this month it will initiate the normalisation programme of its balance sheet through the purchases of treasuries and mortgages.

Latest CPI inflation numbers provided some support to a positive view on the US economy. Core CPI rose 0.4 per cent (1.9 per cent year-onyear), higher than the consensus prediction of 0.3 per cent, and returned to its pre second-quarter trend. One can expect it to rise further as the effects of the recent hurricanes are felt. At the same time, at 4.4 per cent unemployment is at its lowest level in 16 years.

The hurricanes created devastating consequences in the everyday life of many people in the Caribbean and parts of the US. There, the economic data is showing some of that impact: August industrial production fell 0.9 per cent, below the consensus of a rise of 0.1 per cent. Jobless claims were also affected, rising to 298,000 compared to the 245,000 expected and will probably continue to rise. Furthermore, US retail sales were disappointing, falling by 0.2 per cent in August against an expected 0.1 per cent rise. This decline would point to growth of 2 per cent rather than 3 per cent in the third quarter. Keeping to central bank rhetoric, in the minutes of its last meeting, the Bank of England’s monetary policy committee said that “… if the economy continues to follow a path consistent with the prospect of a continued erosion of slack and a gradual rise in underlying inflationary pressure then … some withdrawal of monetary stimulus is likely to be appropriate over the coming months”. Sterling rallied to its highest level in the wake of the Brexit vote.

UK 10-year gilt yields rose, and money markets are now pricing almost 76 per cent chance of a rate rise in November. However, economic data is starting to show the negative effect of Brexit and its implications: GDP growth has been coming in softer and real wages are still low.

While in Florence, UK prime minister Theresa May provided some clarity on the progress of Brexit negotiations. The location was chosen for the UK’s history of economic and trading partnerships with Florence to stress that as the UK leaves the European Union it will retain those close ties.

The European Union is negotiating from strength. Recent economic data has been strong, with solid purchasing managers index and industrial production numbers, rising employment and growing manufacturing output – which should lift gross domestic product in the third quarter.

Earnings have been strong and, while the appreciating euro will is likely to affect earnings, the strong fundamental picture and arguably cheap valuations if you adjust for potential margin catch-up make European equities attractive on a relative basis.

Despite all of this, the space continues to be quite under owned by global investors. At the last European Central Bank press conference its president, Mario Draghi, acknowledged that the recent euro strength should be carefully monitored as it could have an effect on growth and price stability, hence suggesting that quantitative easing would be linked to the direction of the euro. More clarity on QE is expected at this month’s ECB meeting.

Emerging markets continue to be the best-performing equity markets in the year to date (up 27 per cent) with China (up 43 per cent) the top performer along with Poland, also up 43 per cent. Data from China has continued to come in strong in the second quarter, with a small slowdown in August most likely to have been driven by the government’s supply side reforms to cut capacity. At 6.8 per cent, growth is expected to continue to be strong for the rest of the year.

For the time being, everyone is in wait-and-see mode ahead of the Communist Party Congress starting on October 18, with the announcement on the new party leadership.

Following the CPC, one should expect gradual change in policies.

Then, the focus will move to December’s annual economic conference when the GDP target for 2018 will be decided, and then to March 2018 with the National People’s Congress, after which there will be a change in cabinet ministers and the governor of the People’s Bank of China.

With a positive fundamental growth outlook and strong earnings which are set to outpace developed market earnings, one can foresee room for further upside in emerging market equities.

The timing and scale of central bank tapering and North Korea unknowns are sources of potential risks and reasons to be somewhat cautious, although select opportunities such as those in European and emerging market equities make sense within a diversified multi-asset class portfolio.

The damage to the Caribbean and southern US by hurricanes will be seen in industrial production data

Ilaria Calabresi is a vice president at J P Morgan Private Bank