We’ve written before on both the potential secular impact of the Trump administration’s tariffs on growth and inflation, as well as what cyclical indicators are suggesting for the US economy. To summarize, cyclical measures of slack (such as employment figures and capacity utilization) have long suggested that slack in the economy is dissipating, which normally presages inflation. With respect to the tariffs, there does not to appear to have been a major impact on the economy yet. As a result, though inflation has picked up slightly, these concerns have not materialized in asset pricing. However, we believe that there is reason to think that inflation risks may be coming to a head soon.
Market pricing of inflation, as measured by five-year breakeven inflation (BEI), is still benign. BEI is the difference between the five-year nominal yield and the five-year treasury inflation protected (TIP) yield, also known as the real yield. This difference represents the implied level of compensation that investors demand for nominal bonds. This measure has hovered around 2%, which the Federal Reserve’s “goldilocks” scenario, so to speak, suggesting a sanguine market outlook.
The path of inflation will likely be more polarized than market pricing suggests, especially as tariff concerns accelerate. We have begun seeing some evidence that businesses are preparing for more aggressive tariffs. In August, the ISM Purchasing Manager’s Index (PMI), a survey of manufacturers’ purchasing managers and a leading indicator of inflation, hit a 14 year high, suggesting that businesses are building inventory ahead of a worsening trade outlook.
This would accord with our previous commentary on earnings transcripts in August, which showed businesses beginning to prepare for an escalation of the trade war. The timing of the PMI move also is in line with the August announcements from the US on the second round of tariffs ($200B proposed at the time, and in place as of this writing).
Energy prices have also steadily risen since mid 2017, providing an additional support to inflation. As growth in the developed world continues to pick up, we can expect the recovery to further support energy prices.
These indicators, in addition to the strong labor market and continued strength in consumer sentiment and spending, suggest an opportunity to be long breakeven inflation. To do so, one might choose to go long the real yield and short the nominal, betting that the spread would widen — i.e., that nominal bonds would decline more than TIPS.
We continue to monitor these developments closely.
