With the Standard & Poor’s 500 index and Dow Jones industrial average at all-time highs, and with yields on Treasury notes rising, some market watchers say the action may suggest a hedge against the return of inflation.
This idea is rooted in the thought that the incoming Trump administration will be able to cut taxes and raise fiscal spending, known loosely as a reflation policy, and boost growth, especially in a low interest-rate environment. Although the Federal Reserve raised interest rates in its December meeting, with the Federal Funds target rate range at 0.50 to 0.75 percent, short-term interest rates remain historically low.
However, considering that the incoming Republican administration has not laid out any concrete policy statements, it might be too soon to tell if inflation may be coming — and that leaves investors at a crossroad. Additionally, some financial market watchers are skeptical that any short-term inflationary bump from these policy changes will offset the structural issues of excessive debt, technological change and several years of disinflation.
Expectations are moving faster than reality. The stock market’s move to all-time highs on expectations of policy change may be premature,07″It is a bit of talk at this point.”
She says President-elect Donald Trump’s appointees won’t be in place until the first quarter, and it will be mid-year before any potential legislation is passed.
[Read: 8 Huge Mistakes That Investors Made in 2016.]
“Then you have that lag time between passage and implementation and the lag time between implementation and effect on the economy, so I think that they reality of the actual reflation trade is more of a late 2017-early 2018 play,” she says. “I’m not saying it won’t get there, but I think the market may have moved in advance of the actuality.”
Sal Bruno, chief investment officer and executive vice president with New York-based IndexIQ, says there is a “strong possibility” of reinflation. “There’s a strong possibility it could happen very quickly, but it’s possible some of the assets have gotten a little bit ahead of themselves,” he says.
Ron Weiner, managing director and partner of RDM Financial Group at Hightower in Westport, Connecticut, says stocks are richly valued at this point.
“If you step away from all the discussion, hyperbole and emotion, U.S. stocks are trading at 17.4 times forward earnings to the S&P when the long-term average is in the 15 area,” Weiner says.
Anecdotally, Weiner says their more conservative investors are also expressing interest in having a heavier allocation in the stock market, “which is tantamount to your cab driver giving you stock tips.”
What to do now. Bruno says much of the current action in the markets is likely speculation since there’s little concrete policy information. That could set up stocks for a “buy the rumor, sell the news” trade, which means stock values deflate once actual legislation occurs because the news is priced into the market.
Vail says for investors who want to position themselves for reflation, it might be wise to wait for a pullback.
[See: 7 of the Worst Stocks to Buy for 2017.]
“I would hold off adding substantial amounts to the reflation trade, at least from an inflation protection standpoint, for at least a few more months, although it’s hard to argue against momentum,” Vail says. “And candidly, momentum is favoring U.S. equities. I would expect to see some sort of a pullback in those markets in the interim, not just in the equity market, but in the long bond market as well. They’ve both gone a bit too far, too high.”
But just because the markets may have overshot on the upside doesn’t mean investors should try to time the market, Weiner says, noting that being out of equities and trying to come back in is really trying to make two bets.
Both he and Michael Sheldon, chief investment officer at RDM Financial Group, forecast higher slightly higher interest rates and a bump in inflation in 2017, but neither to be significantly higher.
“It’s certainly possible we may see a short burst of inflation over the next few quarters, but it seems unlikely we’ll see a sustained period of high inflation,” Sheldon says.
For fixed-income investors, Vail says the best way to get exposure to market movements is via Treasury Inflation-Protected Securities, better known as TIPS.
“[TIPS] absolutely will be influenced by investors’ perception of inflation and inflation expectations,” she says.
Because expectations of higher interest rates and a market that may be more volatile, Weiner and Sheldon say they want to hold companies that won’t be hurt by higher rates. Sector-wise, they are overweight in energy, financials and technology. On the bond side, they are staying in short duration, holding maturities of one to three years on average in lower investment-grade corporate bonds.
Bruno says more aggressive investors may want to consider commodities for their portfolio that typically rise in inflationary environments. Investors with a high risk tolerance can get direct exposure through the futures market. A less risky but indirect investment is to buy shares in the commodity producers, Bruno says.
“You can go into energy companies, industrial or base metal companies which pull the copper out of the ground; they tend to do well also. That way, you don’t have to deal with the [futures market] issues,” he says.
However, he says, commodities should only be a small portion of anyone’s portfolio because these can be volatile. When thinking about asset allocation in a time of potentially higher inflation, he says investors should have a core holding of short-term debt instruments like Treasury bills.
“They tend to do well in times of inflation ramping up. This was especially true in the 1970s,” he says.
In addition to having some commodity holdings, he also likes real estate investment trusts, which he says seem like a conundrum in a rising interest-rate environment.
[See: The 10 Best Ways to Buy Real Estate.]
“REITs also have the underlying value of the property,” he says. “In some ways, it’s a floating rate as well. Even if interest rates are going up, if there’s a better economy, you have a higher occupancy rate so they can charge higher rents.”
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Inflation May Be a Harsh Reality in 2017 originally appeared on usnews.com
