It was colder on New Hampshire’s Mount Washington the other day than on some parts of Mars.1 And from what we’ve heard, Mars isn’t all that tropical.
Like thermometers during the nation’s recent deep freeze, inflation hasn’t wanted to budge higher either—in fact, it’s remained low since the financial crisis. Post-crisis stimuli, including historically low interest rates, have helped pump up stocks, but wages and the prices of goods and services have been muted.
As some market observers see a path to an inflation uptick in 2018, it makes sense to dive into what that could mean. The Federal Reserve will certainly be on the lookout. It continually cites inflation as key to its assessment of interest rates. As for investment implications, would higher inflation give this low-volatility market a shiver? And if so, what can investors do to bundle up? Let’s take a look.
Source: The Federal Reserve; core PCE measures personal consumption expenditures excluding food and energy prices
Stubbornly low inflation could be attributed to a number of factors. One is that it’s a natural result of the financial crisis—consumer spending typically declines amid financial and labor market uncertainty. Demographics could be at play as well with aging populations possibly holding economic growth back.
Interestingly, technology could be another.
Dallas Fed President Robert Kaplan posits that it may be taking the economy longer to adjust to the new, tech-driven avenues companies have to manufacture, sell, and distribute goods and services. “The obvious ones you think of are Uber vs. taxis, Amazon vs. retail, Airbnb vs. hotels. But every business is facing disruption. What we’re finding is increasingly businesses lack pricing power.”2
There may be signs
For one, some market observers believe the tight labor market (i.e., when there are more jobs than workers) could finally be ready to kick-start long-awaited wage growth (i.e., fewer workers to compete for jobs means higher wages to entice them to work).3
Also, select economic data may be showing some inflationary tendencies. Raw material prices have been rising and the Institute for Supply Management reported that US manufacturing increased at its fastest clip in three months in December.4 And that followed several purchasing managers surveys from around the world suggesting that supply constraints were on the rise.5
While that is a normal part of accelerating economic growth, should demand continue to eat away at supplies and result in higher prices, it may help propel inflation.
The Fed's dilemma
The Fed’s preferred inflation measure, the core personal consumption expenditure (PCE) price index, which measures prices paid for goods and services minus food and energy prices, came in at 1.5% year over year,6 still below the Fed’s 2% target.
If inflation shoots higher, the Fed may have to veer from the gradual hiking path it’s been on and raise rates at a greater clip than the three 25-basis point hikes indicated for 2018. Should that occur, stock market volatility could increase. In another scenario, inflation doesn’t move higher, yet the Fed continues to raise rates as part of its ongoing effort to normalize monetary policy. That could trigger a sell-off in risk assets and potentially help usher in a recession.
According to the minutes from the Fed’s December meeting, “Participants discussed several risks that, if realized, could necessitate a steeper path of increases; these risks included the possibility that inflation pressures could build unduly, perhaps owing to fiscal stimulus or accommodative financial market conditions".7
If you're an investor
On the plus side, an inflationary market could indicate better economic growth. But some market observers believe an inflation surprise, even a modest one, could be enough to shake the markets.
What equities could be in the crosshairs?
- Price growth could boost the stocks of financial, energy, and materials companies as demand increases amid economic growth. Conversely, stocks sensitive to rising interest rates like utilities and telecoms, which may have a harder time raising prices due to regulations, could be negatively affected.
What about bonds?
- Treasury inflation-protected securities (TIPS), bonds issued by the government whose face value adjusts to changes in the consumer price index (CPI), could rise, and fare better than corporate bonds or other government notes.
The bottom line: Inflation is yet another reminder to dress your portfolio in diversified layers of equities and fixed income, just as you would layer up when the temperature drops to lows that even start to nip at Jack Frost’s toes.
1. Koren, Marina and Meyer, Robinson. “It’s colder than Mars out there,” The Atlantic, 29 Dec. 2017. https://www.theatlantic.com/science/archive/2017/12/cold-weather-united-states-mars/549386/
2. Appelbaum, Binyamin. “Fed’s Kaplan Says Technology Is Holding Down Inflation,” The New York Times, 5 Dec. 2017. https://www.nytimes.com/2017/12/05/us/politics/federal-reserve-kaplan-inflation.html
3. Kitroeff, Natalie. “U.S. Job Market’s Strength Is Allowing More to Share in Pay Gains,” The New York Times, 5 Jan. 2018. https://www.nytimes.com/2018/01/05/business/economy/jobs-report.html
4. December 2017 Manufacturing ISM® Report On Business®, 3 Jan. 2018. https://www.instituteforsupplymanagement.org/ISMReport/MfgROB.cfm?SSO=1
5. McCormick, Liz and Verma, Sid. “Inflation Risks May Shake Global Markets,” Bloomberg, 4 Jan. 2018. https://www.bloomberg.com/news/articles/2018-01-03/inflation-is-dead-camp-faces-big-risk-as-price-pressures-bubble?cmpid=BBD010418_MKT&utm_medium=email&utm_source=newsletter&utm_term=180104&utm_campaign=markets
6. “Personal Income and Outlays, November 2017,” Bureau of Economic Analysis, 22 Dec. 2017. https://www.bea.gov/newsreleases/national/pi/2017/pi1117.htm
7. Minutes of the Federal Open Market Committee December 12–13, 2017. https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20171213.pdf