4 Ideas For Today's Low-Inflation Environment

Includes: AGG, GLD, HYG
by: Russ Koesterich, CFA

There's certainly no shortage of things to worry about right now related to the U.S. economy. But one thing we're not too worried about right now: inflation. Not only is inflation low, but the latest numbers show it's actually falling. And as I write in my commentary this week, inflation is unlikely to become a problem in the United States for at least another 12 to 18 months. Why? There are a number of headwinds keeping U.S. prices low in the near term.

These include ongoing anemic wage growth and continued tepid bank lending, both of which I wrote about in a post on inflation earlier this year. Plus, while the U.S. economy is expanding, recent economic reports suggest growth has softened this quarter. One other factor has also been helping to keep prices down: greater U.S. energy production. The surge in domestic natural gas and oil drilling has led to lower, more stable energy prices.

So what are the implications for investors of a continuing low inflation environment? Here are four.

  1. Stick with stocks. With inflation low and falling, the Federal Reserve can afford to ere on the side of too much stimulus. This means that the Fed is unlikely to quickly remove monetary accommodation. This is probably good news for stocks, which I believe can continue to move higher over the next six to 12 months.
  2. Still hold high yield. Continued Fed stimulus is also potential good news for high yield, at least in the near term. As I recently noted, for yield hungry investors there are few alternatives to this asset class in today's record low rate environment. One way to access high yield is the iShares High Yield Corporate Bond Fund (NYSEARCA:HYG).
  3. Maintain an allocation to gold, but consider keeping it small. Low inflation is likely bad news for gold. As inflation drops, investors are less focused on inflation hedges like gold. In addition, lower inflation and stable nominal rates mean that real interest rates are rising, which could hurt gold.
  4. A bond market meltdown isn't imminent. Low inflation confirms my 2013 outlook for interest rates. While I expect rates to rise this year, with the U.S. economy slowly normalizing and the Fed likely to take its foot off the accelerator very gradually, rates should rise slowly.

The bottom line: One silver lining of today's slow growth environment is that inflation is unlikely to be a problem before 2015.

Source: Bloomberg.

Original Post

Disclosure: The author is long HYG.

Disclaimer: Bonds and bond funds will decrease in value as interest rates rise and are subject to credit risk, which refers to the possibility that the debt issuers may not be able to make principal and interest payments or may have their debt downgraded by ratings agencies. High yield securities may be more volatile, be subject to greater levels of credit or default risk, and may be less liquid and more difficult to sell at an advantageous time or price to value than higher-rated securities of similar maturity. Gold and other precious metal prices may be highly volatile. The production and sale of precious metals by governments, central banks or other larger holders can be affected by various economic, financial, social and political factors, which may be unpredictable and may have a significant impact on the supply and prices of precious metals.