The recent jump in global bond yields represents a reflationary reawakening just a year after deflation and recession fears were dominant. Is this another false dawn? We don’t think so. This is an important psychological shift for investors previously obsessing over downside risks to growth and inflation, typified then by the talk of “secular stagnation” and “liquidity traps.”
The latest trend started in July when bond yields bottomed at record lows. Signs of a global growth pickup stoked the more confident mood, as did Donald Trump’s surprise U.S. presidential victory. We believe this reflationary phase, which central banks have been trying to achieve with years of ultra-easy monetary policy, has further to run.
Wage growth, long missing in the post-crisis expansion, is a crucial part of the reflationary dynamic, as we write in our new Global Macro Outlook Waking up to reflation. U.S. wage gains are feeding higher inflation and solid consumer spending, supporting profits in the face of rising labor costs. We believe companies have scope to tolerate even higher wage inflation in a stronger growth environment, either by hiking product prices or through a modest decrease in profit margins. Our analysis shows that profits can improve even with rising wages—indeed, this is a hallmark of reflationary economic phases, as the chart below shows.
Wages and profits can, and typically do, rise together during the reflationary phase of economic expansions. In the U.S., this was the case in the late 1980s, late 1990s and the mid-2000s. The key ingredient? Solid and rising aggregate demand.
The lack of stronger wage growth was a root cause behind fears of the U.S. economy’s fragility and the downside risks to inflation. Thus, it would be misleading to think that rising wages have a direct link with subsequent economic downturns. Economic cycles do not die of old age, as the Federal Reserve has repeatedly noted. In this case, we see no reason to believe that the seeds of reflation will sow the expansion’s demise just now. Most recessions can be explained by a sudden hit to aggregate demand, either due to some external, financial or policy-related shock.
This U.S. profit-wages dynamic has the potential to broaden and go more global. Any uptick in U.S. capital investment or productivity kick would give companies even more flexibility to lift wages. Elsewhere, this virtuous cycle is starting to take shape. In Europe, the slack created by the 2007-08 and 2011-12 crises is slowly being taken out. Labour market reforms have expanded the workforce in Japan, helping explain why wage growth remains limited even with the country’s unemployment rate at three-decade lows. A better synchronized global recovery would make this bout of reflation more powerful.
Global structural challenges do remain, particularly the record debt levels across the world. Combined with low growth and aging population, this is likely to hold down long-term bond yields in Europe and Japan. With financial markets much more tightly integrated globally, these external forces should limit how high U.S. yields can rise. And even in the U.S., where household debt levels have been reduced, leverage remains higher than at the start of previous tightening cycle. This implies any given increase in policy interest rates is likely to have a bigger economic impact than was the case pre-crisis.
There are risks to our outlook. U.S. President Donald Trump has raised hopes for looser fiscal stimulus, but the makeup of any changes is key. His approach to trade and foreign policy could present risks. Unexpectedly rapid U.S. dollar appreciation could cause emerging-market instability with global spillovers.
But we believe a moderate rise in the dollar is more likely, and the support for profit margins from better wages, spending and nominal growth reinforces our broadly positive view on risk assets and equities in particular. This has been far from a typical recovery: Healing the post-crisis economic wounds has meant U.S. businesses and consumers took longer to regain confidence and animal spirits. These now seem to be revving up.
The revival of animal spirits may start to drive more investors out the risk spectrum, reinforcing our expectation that there’s potential for a risk appetite recovery. Finally, modestly higher bond yields support our view that the rotation into value and momentum shares away from low-volatility equities likely isn’t over. Read more market insights in my full Global Macro Outlook.
Jean Boivin, PhD, is head of economic and markets research at the Blackrock Investment Institute. He is a regular contributor to The Blog.