Macq-ro Insights: The Great Divergence: Inflation and Policy

Please refer to page 29 for important disclosures and analyst certification, or on our website www.macquarie.com/research/disclosures. GLOBAL Why this issue matters to investors 1) We believe core inflation is determined by local economic factors 2) Underlying inflationary pressures in the US should continue to grow, even if slack (and low inflation) persist globally 3) Firming US inflation should help offset the impact further Fed rate hikes may have on the USD 4) A return of healthy and benign US inflation should be a positive for equities Our forecasts: Please see the 19 July 2016 The Global Macro Outlook: Keep calm and carry on. Online access to our global macro forecasts is available upon request Analyst(s) Macquarie Capital Markets Canada Ltd. David Doyle, CFA +1 416 848 3663 david.doyle@macquarie.com Brendan Livingstone +1 416 848 3521 brendan.livingstone@macquarie.com Macquarie Capital Securities (Japan) Limited Peter Eadon-Clarke +81 3 3512 7850 peter.eadon-clarke@macquarie.com 11 August 2016 Macq-ro Insights The Great Divergence: Inflation and Policy  A central question facing investors is the magnitude of inflation divergence that is possible between developed economies. The view one has on this issue is an important input for the policy outlook and asset allocation.  One popular perspective holds a global view of inflation – that global slack determines local inflation. Our work suggests otherwise. We find significant evidence that local conditions drive underlying inflation. This is particularly evident for the United States, the primary focus of this report. Core inflation is determined by local economic factors  Evidence supporting locally driven inflation includes, i) a wide range of core CPI inflation rates in the developed world, ii) weak (and declining) pairwise correlations across country core inflation rates, iii) both US core inflation and services inflation exhibiting negligible correlations with other major developed economies, iv) US services inflation sharply diverging from the euro area’s since 2012, v) increasing evidence of accelerating US wage growth despite output gaps remaining substantial elsewhere in the world.  Underlying US inflation is continuing to firm. Services comprise roughly three-quarters of core inflation indices and are picking up steam. Core PCE services inflation is 2.3% YoY and the core services CPI is 3.2% (2.8% ex-shelter). Momentum is broadening. Two understudied indicators (the median CPI and sticky price CPI) have moved to post expansion highs. This momentum should soon become evident in headline numbers as the USD and oil are shifting from headwinds to tailwinds. The implications of the return of benign US inflation  Growing evidence of a pick-up in US inflation should lead to a modest back-up in the 10 year Treasury yield (as inflation compensation moves higher). This is likely to create conditions supportive of further Fed rate hikes, despite ongoing accomodative policy elsewhere.  Continued firming in underlying US inflation should offset much of the impact on the USD despite ongoing policy divergence (a similar move to the 2H14 and early 2015 period is unlikely). Our work across geographies illustrates that policy divergence is appropriate given the divergence in local economic conditions. Moreover, we find that the US economy has become better insulated from potential USD strength following the rapid decline in its energy investment over the past two years.  Our outlook for inflation suggests the real fed funds rate (nominal rate less inflation) should move deeper into negative territory over the coming 12 months, a positive for gold. It should also be positive for equities as the return of healthier and benign inflation will provide a boost to nominal GDP growth (and corporate earnings growth). Moreover, equity market valuations have typically been higher during periods of benign (1 to 4% inflation) than other periods, and financial repression should continue to boost equity valuations by keeping sovereign yields low (see: Financial Repression for decades). Macquarie Research Macq-ro Insights 11 August 2016 2 Executive Summary: Inflation divergence means policy divergence  One of the central questions facing investors today is the magnitude of policy divergence that is possible in a global financial system that puts only minimal constraints on the free flow of capital. This is becoming an increasingly important question for the outlook for US monetary policy as economic conditions in other major economies favour ongoing policy easing.  Market expectations suggest that the Fed may hike just once over the next 18 months. This outlook is driven by a widely held belief that hikes of greater magnitude would trigger further USD strength. Underpinning this perspective is that global factors predominantly drive the inflation outlook in local economies (including the US). This i