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The inflation year 2019

 Salomons Judgement

While almost every investor is concerned about the timing of the recession in the United States, the ‘pre-recession year’ 2019 may well become an inflation year. With higher short-term interest rates as a result.

Every year around this time we organize an Outlook Seminar for clients at Kempen. Last year, I stated that the financial markets would take another roller-coaster ride. ‘Enjoy as long as possible’ was the message at the time. Sometimes this may not feel so good, but afterwards it’s such a shame if you didn’t get on board. At this seminar, the question came up whether we still have another ride to go. I think a complete ride is unlikely, but it’s also still too early to get off.

Currently, the (investment) world is particularly concerned with the timing of the expected recession in the United States. In a previous column I wrote that the most obvious recession year, according to the signal that the bond market sends out, is 2020. In the past few weeks, I have not seen any research report claiming otherwise. There is consensus on 2020 … so no money to be made there.

So, let’s look at 2019. The year before the recession, in which inflation becomes the story. How the ghost of recession will reappear is still unclear. Think of a crocodile’ jaw. The jaw can close at the top (return on capital) as a result of the deflation of excesses in the financial markets, as was the case during recent recessions. The lower jaw can close when capital costs and interest rates go up, usually as a reaction of the central banks to a higher inflation in the real economy. For the purists: it’s also possible that both jaws will shut.

Crocodile

During the Outlook Seminar last year, I conjured up the crocodile when I was looking for excesses and/or inflation. Excesses in the market for corporate loans remain a problem. The interest coverage (the amount of times that an enterprise earns its interest costs) remains low, but is still manageable for the time being. Financial managers don’t earn the job they have if they haven’t financed debts with a long-term maturity at fixed rates. What also helps is that the United States bank loans account for only 18% of the non-financial debt. As a result, there is less instability in the financial sector during bankruptcies.

And then on to inflation, something I haven’t worried about for years. It’s probably my Japan experience. But something is shifting, and if nobody worries, then maybe I should be the one to do so. Because the Fed might be right a second time. This year, for the first time, it has been able to practice what it has been preaching by raising interest rates a total of four times. For the first time in years, the Fed does not have to backtrack because of lower market expectations.

The market counts on a US interest rate of 2.37% by the end of 2018, 2.84% by the end of 2019 and by the end of 2020 too. The dot plot indicates that the Fed will charge an interest rate of more than 3% at the end of 2019, and will continue to increase to 3.4%. Why? Apparently, the central bank sees something coming.

And the longer I think about it, the more I see something coming as well. The IMF sets the cyclically adjusted US government deficit at 6.8% next year. As mentioned earlier, money growth is falling, and credit growth is picking up. This trend continues on the basis of the leading indicators. Wage growth, now 2.9%, will continue to accelerate if we can believe the rising ‘quit rate’. Finally, the savings ratio (6.7%) still has room to decline. These are sufficient reasons to expect 2019 to be the year of inflation. With higher short-term interest rates as a result.

The author

Roelof Salomons

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