As the global disinflation shock turns

Bruce Kasman, Joseph Lupton

Over the past two years, a significant disinflationary impulse has dampened nominal activity around the world. As this disinflationary impulse fades, however, both nominal and real growth should normalise. Indeed, as this column highlights, the latest signs show inflation and inflation expectations rising, profits stabilising, and capital expenditure inching up.

Over the past two years, a significant disinflationary impulse has dampened nominal activity around the world. The slowdown in real growth in that period has been modest – global real GDP expanded at a 2.7% annualised pace, right in line with our potential growth estimate. However, commodity prices and producer prices declined sharply, which pushed consumer price inflation (CPI) down to historic lows outside of a recession. All collapsed at their fastest pace in decades, excluding the Global Crisis (Figure 1). This in turn, has weighed more heavily on real activity than we had initially expected. But as the disinflationary impulse fades, both nominal and real growth should normalise.

Figure 1 Oil and global producer pricing

In effect, the disinflation impulse reflects a significant positive supply shock in commodities (oil, specifically), reinforced by a somewhat larger than initially assumed negative demand shock. These shocks produced a dramatic rotation in regional and sectoral performance. The emerging markets and commodity producers weakened significantly, with some countries (Brazil and Russia) experiencing deep recessions. Income shifted away from corporates and toward households as inflation slid sharply. This boosted consumption, primarily in the developed markets, while global capital spending stalled.

With the supply shock looking to have stabilised and the demand shock fading, the pricing complex should normalise. We expect producer price inflation to move back into positive territory and consumer prices to rise 2.5% in the coming year – a return to its 2013-14 pace. The pickup should lift corporate profit growth and, in turn, boost business equipment spending and help return the global economy to more trend-like growth. It should also lift inflation expectations, adding to stimulus by lowering real interest rates and further reinforcing the fading of the demand shock. Demand shocks are also fading as prior developed market fiscal tightening has turned neutral (Lupton and Saijid 2016).

Figure 2 Global PPI and CPI

The latest signs are that this rotation in pricing, profits, and real activity is underway. After bottoming in February this year, global producer price inflation has surged to 3.5% annualised in the six months to August – its fastest such pace in five years. Global consumer prices have also accelerated from their February lows and are up 2% annualised in the six months to August (Figure 2). Inflation expectations remain depressed but there are some hints of a firming in the US. The early readings also show a momentum-shift upward in corporate profit growth. For now, the acceleration is from large declines to stability, but we forecast global corporate profits advancing 5-10% in 2017 as nominal GDP accelerates. The leading signs of improvement align with recent indications of a pickup in capital spending. If these trends continue, the fading disinflationary shock will be a key foundation for extending the life of the expansion in the face of gradual Fed hikes over the coming year.

A disinflation impulse that did real damage

When commodity prices began tumbling in 2014 (and kept tumbling through to early 2016, with some ups and downs), we highlighted an identification problem. To the extent that this tumble reflected supply developments, it would boost global growth. By contrast, large price declines from demand weakness often signal impending recession. There were clear signs that both forces were at play – big increases in the production of energy and other commodities at same time that the emerging market credit boom was starting to deflate. In the event, global GDP prices (i.e. the ‘deflator’) decelerated sharply in 2014 and 2015, but real GDP growth also stepped down (Figure 3).

Figure 3 Global real GDP and deflator

We had forecast the commodity supply shock would induce an income rotation toward higher marginal propensity to consume households, which would more than offset the concentrated hit to business spending. However, the hit to business equipment spending, combined with the emerging market demand shock, was larger than we had anticipated. Real consumer spending did accelerate, but this was more than offset by a much sharper deceleration in real fixed investment (Figure 4).

Figure 4 Global real GDP contributions

It now appears that, while a significant share of the collapse in commodity prices owed to a positive supply shock, headwinds to growth across much of the emerging markets and parts of the developed markets constituted a larger negative demand shock than we had anticipated. This demand shock appears to have been concentrated in the goods sector, as global services provided a much-needed buffer to the slide in goods production over the past two years (Figure 5).

Figure 5 Global Purchasing Managers Index

Overall, global nominal GDP slowed to a weak 4% annualised pace in the year ending 1Q16 from a 5.8% average annualised rate from 2010 through to mid-2014. This is the weakest showing on record outside of a recession. The collapse in nominal growth resulted in a significant slide in corporate profits. Globally (on a GDP-weighted basis), earnings per share of listed companies have tumbled roughly 20% since mid-2014. In a recent report, we underscored the linkage between the profit cycle and the business cycle, noting that the recent decline in profit growth over the past two years is a rare outcome typically reserved for recessions (JP Morgan 2016). Not surprisingly, business equipment spending slumped (Figure 6).

Figure 6 Global corporate profits and equipment spending

The coming unwinding of disinflation

Initially the commodity price collapse drove the disinflation impulse. As commodity prices have bounced from their February lows, the pressure on the broad inflation complex is reversing. The most obvious imprint will be felt on CPI. We have long expected a jump in global CPI inflation but have been somewhat surprised that the rise has yet to materialise (Figure 7). We attribute part of this surprise to a lack of pass-through of the recent jump in oil prices into consumer energy prices.

Figure 7 Global headline inflation

However, the outlook still projects that global CPI will rise nearly a full percentage point over the coming months and the model tracking-error suggests the risks are skewed to the upside. The latest data suggest inflation is already starting to strengthen. Over the three months through August, the global CPI has advanced 1.8% annualised. This three-month pace is off a little from June, but is well above the 0.9% lows from earlier this year (Figure 8).

Figure 8 Global headline inflation

Figure 9 Commodity prices and GDP prices

The unwinding disinflation impulse will have broader ramifications. Pricing has been weakened across much of the goods sector but the large declines are stabilising (Figure 1) and overall global GDP price inflation is already starting to rise. Global GDP inflation slumped from 2.5%oya in mid-2014 to a low just above 1% in late 2015 (Figure 9). With commodity prices rising, global GDP inflation has picked up back to 1.7%oya as of 2Q16. If our forecast is right, GDP inflation should strengthen materially to 2.6% by the end of 2017.

Figure 10 Inflation swap, 10y

As consumer and GDP price inflation picks up, inflation expectations should firm. This will likely be a welcome relief to central banks that have struggled to find new tools to shore up their respective nominal anchors. While inflation expectations in the Eurozone and Japan remain depressed, US inflation expectations are showing some hints of a rise of late (Figure 10). The recent pickup in commodity price inflation suggests more firming is in train. After bottoming at -34%oya in mid-2015, commodity price inflation (as measured by the J.P. Morgan Commodity Curve Index) is set to reach 16%oya by year-end. The US ten-year inflation swap has lagged this recovery but the latest firming points toward a correction (Figure 11).

Figure 11 Commodity prices and US 10y inflation swap

Hints of profit and capital expenditure rebound underway

The latest signals suggest that a rebound in global profits is beginning and this is already translating into acceleration in global business equipment spending. For profits, we look to the MSCI earnings per share data. Earnings are reported on an average year-over-year basis and computed on a rolling basis as companies report them. These are computed by country and aggregated using GDP-weights. Based on this metric, global corporate profits contracted 15% in the year ending in 2Q16 (Figure 6).

Figure 12 Corporate profits

However, earnings per share have stabilised in recent months. The year-average pace of earnings has actually inched up 1% in the three months through September.1 The stabilisation in earnings is broadly based across the developed and emerging markets (Figure 12). These latest developments should not come as a surprise given the fading of the disinflationary shock noted above. With global nominal GDP growth projected to rebound, global corporate profit growth could accelerate to nearly 10% in 2017 (Figure 13).

Figure 13 Global nominal GDP and corporate profits

The impact of rising earnings growth is powerful. The slide in profits over the past two years has weighed heavily on business equipment spending, as indicated in Figure 6. As such, the stabilisation and likely pickup in profits should provide an important boost to capital spending. In past research, we highlighted more formally in a regression model the strong role profits played in driving the capital expenditure (capex) cycle. The recent stabilisation in global profit growth bodes well for capex, in this regard. Indeed, our monthly global capex proxy (based on capital goods imports and capital goods shipments data) has aligned remarkably well with the higher-frequency percentage 3m/12m turn up in global profit growth (Figure 14).

Figure 14 Global corporate profits and capex spending

Assuming nominal GDP growth accelerates to roughly a 5% annualised pace over the coming year and generates a pickup in profit growth to a near-10% pace, global capex would strengthen by 5%-10%. We do not project capex to expand as robustly as this, but the results point to two conclusions. First, a capex rebound is in the offing if profits recover alongside the fading disinflationary impulse. Second, if the pass-through of rising prices to earnings is as strong as suggested here, the risk to the projected capex recovery would be skewed to the upside.

Emerging market improvement, not emerging market health

If the fading disinflationary impulse owes to the fading commodity supply shocks and emerging market-dominated demand shocks over the past two years, it stands to reason that the emerging markets would be the biggest beneficiary. Indeed, assuming the firming in profit growth translates into some acceleration in capex, the impulse to the goods-producing sector should be meaningful and translate into a bigger boost in the more goods-intensive emerging markets. Similarly, the rise in commodity prices of late will support emerging market incomes somewhat more via the terms of trade channel. Not unrelated but providing an added boost, Brazil and Russia’s exit from recession underlies a big part of the emerging market growth upswing in our forecast. That said, with emerging market leverage still near all-time highs, the slowing in the credit cycle will remain a headwind. Moreover, while commodity prices have moved up, they remain well below their prior peaks, and the end of the commodity super-cycle (driven in part by China’s rotation away from commodity-intensive growth) means that the commodity-producing emerging markets need to adjust to a new business model. This adjustment will weigh on growth in the near and medium term.

References

J.P. Morgan (2016), Profit stall threatens global expansion, Special Report, 21 June.

Lupton, J and Z B Saijid (2016), “The spirit is willing but the fiscal stimulus is weak”, J.P. Morgan Research, 5 August.

Endnotes

1 Because the MSCI data refer to earnings over the past year, the level of earnings is a 12-month average. We then focus our analysis here on the %3m growth rates. As such, the frequency is a %3m/12m basis (%3m change of a 12m average).

Disclosures

Analysts' Compensation: The research analysts responsible for the preparation of this report receive compensation based upon various factors, including the quality and accuracy of research, client feedback, competitive factors, and overall firm revenues.

Principal Trading: J.P. Morgan and/or its affiliates normally make a market and trade as principal in fixed income securities discussed in this report.