Inflation may be - on some measures - subdued, but don't assume it can be consigned times when people wore flared jeans and Gerald Ford was President, this article argues.
Finding investments that can offer shelter against rising inflation will be increasingly on asset allocators’ agendas in the years ahead, CIBC Atlantic Trust Private Wealth Management argues in a recent note.
For the past decade or more, a range of forces have kept headline inflation - particularly at the consumer price level if not for asset prices such as real estate - subdued. Recent years have even seen the opposite economic issue of deflation often causing more heartburn for central bankers.
But inflation may be set for a return and investments will have to adjust with such a scenario in mind, David L Donabedian, CFA, said in a note from the US wealth management house.
“Thus, we think it is appropriate to consider scaling into assets that have historically performed well during rising inflation environments. There are selective opportunities within the bond market (inflation-protected securities or floating rate debt); and in the equity markets there are certain companies and industries that may be able to expand their profit margins by controlling costs while enjoying better pricing power,” he wrote.
“By and large, though, the best inflation protection may come from assets with low correlation to the stock and bond markets. Traditionally, such investments have been called `real assets’ -ownership interests in tangible entities such as infrastructure, timberland and farmland. Direct ownership of real estate properties (as opposed to publicly traded real estate investment trusts) also fall into this category. Real assets are, in essence, the structures and natural resources that support the functioning of the economy, and their revenue and cash flow streams tend to respond favorably to moves in inflation. They also can produce a significant income stream for investors,” he continued.
His note, entitled Is Inflation Whipped? reminds readers of how much has changed since 1974, when Gerald Ford, US President at the time, encouraged US citizens to wear “WIN” buttons (“Whip Inflation Now”). Today, Donabedian argued, the acronym could mean “Where’s Inflation Now?”
There are signs investors are starting to push inflation higher up their "worry list". The quarterly Fidelity® Advisor Investment Pulse survey recently showed a stirring of concern. On a list of 14 potential topics, inflation ranked joint last with alternative investments, but opinion is starting to stir. In the first quarter of this year, just over 3 per cent of advisors cited inflation as an area of focus. While still very low, the absolutely level is the highest since the start of 2014. (See story here.)
Higher interest rates to curb inflation, if they arrive, will prove a jolt to investors and financial industry players used to ultra-low, or even negative, rates since the GFC. The era of negative rates has been a mixed blessing, hurting bank margins. (See an editorial comment here.)
Subdued - so far
Inflation has been subdued despite the kind of background conditions that might have suggested a revival, the CIBC Atlantic trust author said.
“Despite a long economic expansion, a robust job market approaching full employment, massive money creation by central banks and inflated financial assets, price pressures in the economy are mostly absent,” Donabedian said, pointing out that the Federal Reserve’s favorite inflation indicator – the Core Personal Consumption Deflator – is below the Fed’s 2 per cent target.
Donabedian argued that his firm believed the cyclical and structural forces that once subdued inflation are weakening and that inflation is likely to go up over a period of several years.
“The recovery from the Great Recession has been one of the slowest on record. Thus, it has taken longer for the output gap (i.e., `slack’ or unused capacity) created during the downturn to be closed. This lack of pressure on resources - both goods and labor - has been a major factor in keeping cost and price increases muted. But, it has been 10 years since the first signs of the Great Recession emerged. The most comprehensive work on the global history of financial crises concludes that it takes “about a decade” for an economy to normalize after the bursting of a debt bubble. While there is no way to be precise on the timing, the output gap no longer exists,2 and odds favor some increased price pressures from an economy operating closer to full capacity,” he wrote.
A tight labor market in the US – the current unemployment rate is just 4.3 per cent, and there are 6.2 million unfilled vacancies, hasn’t yet triggered inflationary wage pressures, but signs of an inflection point are building, he continued.
Donabedian also cautioned that measures of wage growth could be misleading because the most widely followed data is average hourly earnings, which attempts to capture wage trends for the average employee. But while average hourly earnings have gradually risen over the last four years, they are well below average at 2.5 per cent; demography is a factor: “An unusually large number of higher-paid baby boomers have been retiring over the last three years. At the same time, the strong job market finally has attracted lower-wage employees back into the labor force. While both trends could be viewed as signs of prosperity, they have a depressing effect on the average wage rate.”
“We are not warning of an impending “great inflation.” Demographic and other forces make a rerun of “That ‘70s Show” unlikely. But the CIBC Atlantic Trust Asset Allocation Committee believes that inflation rates are likely to be in a rising trend over the next few years and that markets are not well prepared for it. Upside inflation surprises likely would speed the pace of the Federal Reserve’s interest rate increases, an unambiguous negative for fixed-income investments. While certain industries can thrive in a rising inflation environment, the accompanying tightening in monetary policy likely would be a headwind for equity markets in general.