The global economy is getting stronger. The inventory correction in global manufacturing is over. The US housing bust is not feeding through into a US consumer slump or even a generalized curtailment of credit availability. And as long as the doughty US consumer is experiencing rising net worth and firm wage gains, there is no reason for consumption to collapse.
Europe is booming. Japan, where the signs are more mixed (output, exports, investment and jobs are strong but wages are weak), will also boom before the end of the year.
So it is no wonder that bond markets have had a wake-up call. But what exactly is the US bond market discounting?
The answer is growth, not inflation. US inflation-protected bond yields have risen along with the nominal yields of other bonds. That tells us that higher growth will suck liquidity out of the global system just as a fast-growing firm will employ more cash in the business rather than invest in financial assets.
Tips (Treasury inflation-protected securities) yields have another message for us. The difference between the yields of similar-maturity US Tips yields and those of Treasuries is a measure of market expectations of inflation. This has not budged. So the bond market expects no increase in inflation and is simply discounting a revised view of Federal Reserve policy and of prospects for economic growth.
This is both good news and bad news. The good news is that the equity markets will probably get over the shock of rising bond yields pretty quickly as the higher growth gets discounted in earnings and higher real risk-free rates feed into the discount factor.
The bad news is that the bond market is still too sanguine about inflation. It is most unlikely that we can get higher growth without higher inflation at this stage of the economic cycle. Labour productivity in the US has slowed and unit labour costs are on the rise. That will feed through as higher prices or lower profits – I reckon it will be both.
Pricing power
More vital by far is that the world (not just the US) has little spare capacity to meet fast-growing demand. And Chinese and Asian export prices are already rising, not falling. This returns a hefty chunk of pricing power to non-Asian manufacturers. Down the road, when the yen recovers, the pressure of international trade prices will become more severe. But even now, this powerful engine of global disinflation is on the wane.
| US TIPS yields and implied inflation expectations |
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| Source: Datastream |
Now supposing I’m wrong on this and tightening resource utilization does not end up as higher inflation. In that case, we will get lower profits, as costs will be rising faster than output prices. So higher global growth and tighter resource utilization that resulted in production costs rising faster than output prices would have two impacts.
First, it would reduce corporate cashflow margins. Second, despite lower margins, it would probably result in rising corporate investment. This would reduce the rate of growth in free cashflow – and it is free cashflow that has kept global equity markets rising as firms poured their excess cash into financial assets of all sorts and sizes.
Dollar deficit
Finally, the story of the past five years has been the recycling of Asian and Opec export revenues into dollar assets. This has been an important source of global liquidity. Higher global growth and particularly a buoyant US consumer will do little to cut off this source of funding for financial assets, as the US current account deficit will remain very big, despite stronger growth in America’s trading partners. So dollars will continue to flow out over the US external deficit.
But an increasing proportion of this dollar recycling has been into US corporate bonds rather than into US treasuries. US companies, hedge funds and real estate sectors have turned into borrowers in financial markets. The proceeds of corporate borrowing are additive to their own internal resources and are being used to buy back their own shares, for M&A activity and of course for highly leveraged private equity deals. All this will suffer if bond yields rise further.
And the biggest threat to global financial market fortunes is from the development of sovereign wealth funds. They are an investment alternative for central banks to simply giving Uncle Sam back his surplus dollars to finance yet more excessive consumption. Such diversification could put pressure on all US financial assets as treasury yields rise.