Worried Inflation Will Push Interest Rates Higher Than You Expect? Don’t Be.

On February 5, the Dow Jones Industrial Average shed 1,600 points in afternoon trading, before ending the day 1,175 points down (minus-4.6%) – after losing 666 points (the number of the Beast!) on the previous trading day. America’s bellwether index has now lost 7% in just two days and given up all its gains in 2018.

Asia’s stock markets followed in the downdraft. Japan’s Nikkei Index slumped 2.25% on February 5 and another 4.7% the next day. Over the two days, Hong Kong's Hang Seng Index and Singapore's Straits Times Index fell by 6.1% and 4.9%, respectively, while China’s CSI 300 slid by 2.9%.

“There is little evidence that the risk of persistently strong wage growth has increased. We see inflation only creeping higher”

But the proximate cause was not a weakening US economy or a banking crisis. On the contrary, the trigger was new evidence that America’s GDP may accelerate more strongly than anticipated. The latest jobs report had non-farm payrolls increasing by 200,000 in January, higher than the expected 180,000. The news coincided with the yield on ten-year US Treasury bonds spiking to 2.8%, from 2% or lower in the past two years.

Market participants put two and two together, and started selling on the fear that inflation may surge as employers are forced to pay more to retain or recruit workers, even as US tax cuts leave more money in their pay packets. The US Fed might then raise interest rates higher and faster than it had been signaling, further raising business costs and cutting into corporate earnings. Programmatic trading, sell orders activated by algorithms, did the rest.       

Time to Rethink the Budget?               

Is it time for CFOs to redo budgets and forecasts, penciling in higher interest rates and thus higher debt repayments and other costs? Not yet, according to an analysis by global advisory Oxford Economics.

“For the advanced economies to record a sustained bout of above-target CPI inflation, we would need to see wage growth take off,” the firm concludes in a new report. “But there is little evidence that the risk of persistently strong wage growth has increased. We see inflation only creeping higher.”

If so, that means US interest rates will remain accommodative in the short to medium term. The Fed’s median projection for 2018 is 2.1%. If that is the assumption you as CFO plugged into the current budget, you should be OK. Moderate rate rises in the US means moderate increases in Asian economies too, particularly in Hong Kong, whose local currency is pegged to the US dollar.

What’s behind Oxford Economics’ confidence in this view? “While some temporary factors holding back wages, such as ultra-low inflation, may now be subsiding or have run their course, other more structural factors such as automation and offshoring remain and could even intensify,” it argues.

The Philipps curve, a single-equation empirical model that posits that decreased unemployment correlates with higher rates of wage rises, remains flat, notes Oxford Economics. That may change as spare capacity in the US labor force dwindles. But the advisory firms believes that “unemployment rates, relative to past lows, may be understating slack, implying that any steepening of the Phillips curve may therefore not be imminent.”

What about external triggers of inflation such as a surge in oil or commodity prices? That can happen, but “it is not in our baseline,” says the report. Crude oil has recovered from it’s the US$30-per-barrel lows in 2016 to around US$60 recently, but prices are still far off the US$130 high in 2008.    

And Asia’s Real Economies?

Other analysts are in broad agreement. “To argue that the US market is currently facing a deep and lasting correction in what looks likely to be one of the best years for the US economy and corporate earnings since the upturn began is both unjustified and too bearish,” says Geoff Lewis, Senior Asia Strategist at Manulife Asset Management. “It has not happened before.”

“We expect that economic growth in the region will be supported by a relatively benign interest rate environment as inflation stays at reasonable levels”

He believes that significant pressure on corporate profit margins will emerge only if wage inflation in the US exceeds 4% year-on-year. Average hourly earnings in January were up 2.9% year-on-year, reports the Reuters news agency.

“Fundamentals in Asia have not changed as earnings continue to be strong, as seen through earnings revisions,” says Ronald CC Chan, Manulife’s Chief Investment Officer, Equities (Asia ex-Japan). “We expect that economic growth in the region will be supported by a relatively benign interest rate environment as inflation stays at reasonable levels."

Says Ghadir Cooper, Global Head of Equities at Barings: "The economic environment continues to be characterized by synchronized global growth, a corporate earnings recovery in emerging markets and tailwinds in developed markets, including the continued European recovery and US tax reforms."

Don’t Forget the Risks

Still, there are risks. Despite what’s happening in the markets, “2018 will be a good year for Asian businesses,” says Ludovic Subran, Chief Economist at trade credit insurer Euler Hermes. But he wants companies to continue monitoring trade easiness, payment delays and financing conditions, which he characterizes as the “three big-ticket items” in 2018 and 2019.

Indeed, a looming global trade war is casting a cloud on the sunny economic landscape. In response to President Donald Trump’s imposition of tariffs on exports of solar panels and washing machines to the US, China has announced an anti-dumping and anti-subsidy investigation into American sorghum, a key US agricultural export to China.

There is also a herd of gray rhinos (probable but ignored risks) and a fleet of black swans (unexpected risk events) that could damage the advanced and emerging economies, including war in the Korean peninsula and the Middle East.

But for now, surging inflation and aggressive interest rate hikes in response to it do not appear to be the most immediate risks that CFOs should worry about. They can safely discount the current hysteria in the financial markets, but should remain alert to other, more plausible threats.     

About the Author

Cesar Bacani is Editor-in-Chief of CFO Innovation.