After years of low inflation, some investors seem to think it won’t return. When global central banks attempted to jump-start the world’s economies with extraordinary monetary stimulus after the global financial crisis in 2008, economists worried that all that money sloshing around would feed directly into rising prices.
Nearly 10 years after the crisis, global economic growth finally is taking off, though inflation remains low. That’s led to the impression that inflation won’t be a problem, some market watchers say. But that may be changing, and many investors aren’t prepared for inflation’s inevitable return.
“The biggest risk that investors aren’t expecting is a pickup in inflation,” says Rob Waldner, chief strategist for fixed income at Invesco in Atlanta.
Santiago Ulloa, founder and managing partner at WE Family Offices in Miami, says the market is too complacent about inflation. “I think everyone is too relaxed, everything is too good to be true,” he says. “When you look at valuations in the equity markets, we don’t feel comfortable. Probably the equity markets will go up for the next few months, but we have been reducing exposure into equities.”
[Read: 7 Tips to Help Your Portfolio Keep Up With Inflation.]
Inflation affects both growth and income investors. Growth investors need to be concerned about inflation dampening earnings and profits. Companies may pay higher prices that can’t always be passed along to consumers, hence earnings shrink. Income investors need investments that won’t be eroded by higher prices.
Signs of rising prices. To be clear, no one thinks the rampant inflation of the 1970s and 1980s is coming. Inflation forecasts for the next few years call for it to remain well under 3 percent, peaking at 2.64 percent in 2019 and up from a projected 2.38 percent this year, according to Statista, but even small increases can eat away at consumer purchasing power.
Because it costs more to buy the same goods, living standards can fall, especially for retirees on a fixed income. Also, once inflation starts creeping up, it’s hard to keep under control and usually requires hikes in interest rates to combat it, which can stifle the economy and trigger a recession.
Already, there are some signs of inflation. The December U.S. consumer price index saw its largest increase in 11 months, with the core CPI rising 0.3 percent. It rose 1.8 percent in the 12 months through December. Inflation break-even rates also are rising, Waldner says. An auction in mid-January saw the strongest demand for 10-year Treasury inflation-protected securities in three and a half years. The difference in yield between 10-year TIPS and 10-year Treasury notes is the break-even rate, which is just over 2 percent.
Despite these signs, market participants are mostly oblivious to rising prices, according to an Invesco survey of global fixed-income institutional investors, Waldner says. Of 79 fixed-income professionals surveyed, who collectively hold $4.4 trillion in assets under management, 58 percent believe rising inflation isn’t a concern.
Waldner says it’s ironic that these investors aren’t worried about inflation now. With global economic growth strong, the U.S. unemployment rate low and one of the country’s biggest tax stimulus laws taking effect, conditions are ripe for inflation to rise. “This is the biggest risk to inflation that we’ve had in a very long time,” he says. “Just as the risk of inflation is rising, investors are exhibiting views that are benign. They’re not set up for this risk, at least according to this study,” he says.
Stronger global economies and rising commodity prices are why inflation could rebound, Ulloa says. The one factor that may prevent this is if technology can keep wages low. “Unless technology allows companies to produce much higher productivity for companies, I don’t see how we can avoid inflation in the future,” he says.
Although a synchronized global expansion, higher oil prices and a much weaker dollar all argue for higher inflation, the numbers are a mixed bag at the moment, says Chun Wang, senior analyst at The Leuthold Group, in a research note. The CPI numbers are higher, suggesting inflation is coming, but producer prices, which is the cost of raw goods, fell in December. Meanwhile, wage inflation, he says, is stuck in a range.
[See: 7 Energy ETFs to Watch in 2018.]
Because of that mixed data, he recommends investors wait a bit before repositioning their portfolios. “It does seem like just about every year the market starts with an optimistic outlook for inflation and a bearish outlook for bonds, only to be disappointed as reality sets in,” he says. “We recommend patience.” So don’t jump the gun and plow into inflation-protected investments just yet.
Even Waldner believes inflation is unlikely to pick up significantly in the next few months. But when it does come, inflation, not the central bank’s rate tightening or other factors, is what will end the bull market, Waldner says. Otherwise “central banks show no desire to bring [growth] to an end. They’re going to let the party rage.”
Where to invest. Inflation can be both an opportunity and a threat to an investor’s portfolio, so this is a good time to review your holdings and assess how well they might perform if inflation rises. If inflation returns, investors have several ways to mitigate or take advantage of its effects.
TIPS are the best-known of the inflation protection assets. Jim Barnes, director of fixed income at Bryn Mawr Trust, near Philadelphia, says TIPS work well, especially if inflation is higher than people expect, and also help with diversification. Ulloa says his firm already has increased its positions in TIPS.
Commodities are another inflation hedge and a way for investors to capitalize on higher prices. Gold is the classic example, but in a research note, Cameron Karami and Bernard Dahdah, commodities analysts at Natixis, say base metals like copper and oil are better bets because of their industrial use, which ties them to the economy. The analysts say investors who want to increase their exposure to this asset class should hold a broad basket of commodities to reduce the risk from a single one.
As inflation picks up, some equity sectors may perform better than others. Sean Darby, global strategist at Jefferies, says in a research note he’s expecting the U.S. economy to move from a disinflationary boom to a more inflationary growth cycle. “A resynchronized global economy, pent-up investment demand, tight labor markets and loose monetary policy are ideal conditions for higher inflation,” he says.
[See: The 10 Best Materials ETFs We Could Dig Up.]
Among the sectors he likes are industrials and transport, which are closely correlated to real economic activity, and financials, particularly banking, which should lead the sector in an economic recovery. He’s modestly bullish on oil, noting it’s “the ultimate global inflation proxy.”
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Are Markets Too Complacent About Inflation? originally appeared on usnews.com
