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Over the long run, investors must successfully manage three key risks: capital risk, reinvestment risk and inflation risk. Capital risk - the risk of sustained loss- is perhaps the most understood of these three risks. However, reinvestment risk (the inability to redeploy investment cash flows to earn a required rate of return) and inflation risk (lost purchasing power) can be just as threatening to investors' ability to achieve their goals.

Investors, especially those dependent on steady income from their portfolios, have become more acquainted with reinvestment risk in recent years, but inflation risk remains a concept of distant concern for many. Years of disinflation, coupled with very low market expectations for future inflation have lulled many into a false sense of security that inflation can't happen here. While it appears unlikely that inflation presents itself as a problem over the near term, looking out a bit further, it is a risk that we believe bears monitoring. In this Outlook Series piece, we explore the potential drivers of inflation over the short and longer term, as well as what can be done today from an investment perspective to address this forgotten risk.

Inflation Drivers

We focus on two key factors that have the potential to drive inflation in an economy: 1) wage-price spirals and 2) credit growth and monetary policy. Wage-price spirals refer to the vicious cycle that occurs when rising wages lead producers to raise prices, which in turn, leads workers to demand higher wages, further driving prices higher. This is one of the key contributors to the high levels of inflation during the 1970s/early 1980s. As the chart to the right shows, there is a relatively high correlation between wage growth and overall inflation. The other source of inflation, credit growth and monetary policy, is at the heart of the famous quote by economist Milton Friedman that "Inflation is always and everywhere a monetary phenomenon." Easy credit and loose monetary policy have the potential to create significant inflationary pressure as increasing amounts of capital bid up limited resources.

Wage-Price Spirals

Today, with unemployment north of 6% and economy-wide measures of wage growth remaining well-contained, the risk of an imminent wage-price spiral is low. However, we are starting to observe signs of potential wage pressure in select areas of the economy due to a shortage of skilled labor in certain industries (Please refer to the "Big Crew Change" Outlook Series piece for more details on the cause of these labor shortages).

For example, toward the end of 2013, manufacturing and construction industries, which represent 8.8% and 4.3% of total employment respectively, were experiencing higher average hours worked than any time since the 1940s. This suggests hiring should pick up in these industries, and indeed, we are beginning to see this reflected in the number of job openings. As the supply of skilled workers in the unemployed population decreases, companies will need to increase pay to incentivize workers to join their company. Wages in manufacturing and construction are increasing today, while wages for all civilian workers remain at a generally flat growth rate.

Longer term, there is a risk that the slack in the labor market is much tighter than commonly believed. Over the past several years, there has been a marked decline in the labor force participation rate in the U.S., as shown in the chart to the right. This has served to help lower the reported unemployment rate, which is based on the number of individuals employed divided by those in the labor force. It is not uncommon to see the participation rate shrink during recessions as discouraged job-seekers leave the workforce, but typically, these people re-enter the job market as economic conditions improve.

Some policy makers believe that a large number of discouraged workers remain, who will enter the workforce as conditions improve further, thus providing a relief valve on wage pressures. However, recent analysis by the Philadelphia branch of the Federal Reserve finds that the majority of the increase in people leaving the labor force over the past two years has been due to retirement, a force that we do not see changing as more and more Baby Boomers hit retirement age. Data which is now pointing more towards this change being structural rather than cyclical suggests that future wage pressures could be more pronounced than expected.

Credit Growth & Monetary Policy

Monetary policy in the U.S. has remained ultra-accommodative since the height of the global financial crisis around five years ago. A prolonged low Fed funds rate, as well as three rounds of quantitative easing (QE), has raised fears of rising inflation as this easy money enters the real economy. Thus far however, most of these funds have not made it out of bank vaults as evidenced by the record level of excess bank reserves deposited with the Federal Reserve.

Though well-behaved thus far, we are monitoring lending activity closely, as it is an avenue for these excess reserves to find their way off bank balance sheets and into the economy. Some of the excess reserves are making their way into the economy. Commercial and industrial loans have been growing at a strong, but reasonable pace. Consumer credit has recently improved and bank lending standards are beginning to loosen. The loosening of standards will help credit growth, as the demand is there from those with lower credit scores, if they can get the lenders to lend to them. The residential side has not seen as much loosening of standards, and growth in this market, though positive, remains slow. An easing of lending standards would be a positive for the economy, but would also likely increase inflationary pressures, as it will release some of the excess reserves. So far there hasn't been traction, and as such we believe near-term inflation is not a concern, however, we run the risk of this bubbling up, and it could happen quicker than can be contained.

Last December, the Federal Reserve slightly eased up on the monetary accelerator by decreasing its bond purchases by $10 billion a month. A second $10 billion reduction in monthly bond buying was announced after the Fed's January meeting. Despite these adjustments, the Fed maintained that exceptionally low rates would remain until well after the unemployment rate moved below at least 6.5%, unless inflation increased above 2.5%.

Longer term, there is a risk that the Fed falls behind the curve in terms of inflation. It is believed that the Fed would be comfortable with a "little" inflation; a concern given that once out of the bottle, inflation can be difficult to contain. The departure of Ben Bernanke and ascension of Janet Yellen replaced a somewhat dovish Chairman with one that is even more dovish. The Fed seems to be of the opinion that it will have no problem unwinding its massive asset purchases and shrinking its balance sheet, but no one has any experience with this process, making the risk of missteps higher. What form these missteps may take remains to be seen, but any will likely push inflation higher rather than lower. Furthermore, with Yellen's very dovish reputation, the odds are the Fed will keep policy too easy for too long versus tightening policy too early.

Managing Inflation Risk Today

When does the risk of higher inflation become Inflation Risk for investors? It happens when inflation is unexpected and overwhelms the returns achievable in the financial markets, resulting in sustained loss of purchasing power of an investor's assets. Although inflation is likely to remain subdued in 2014, greater inflationary pressures are beginning to build in the pipeline, making now a good time to start thinking about ways to manage this risk. Low inflation expectations are currently priced into the market, which should present investors opportunities to not only hedge inflation, but also not pay a lot (and maybe even earn a premium) in doing so.

Treasury Inflation Protected Securities (TIPS) are a common instrument for investors wanting to hedge inflation risk. The par value of a TIP security is tied to CPI, so the faster consumer prices rise, the higher the principal payout will be when the security matures. Since periodic coupon payments are linked to face value, those will also adjust upward in an inflationary environment as the bond moves toward maturity.

TIPS, however, are not without risk. They suffered losses after October's CPI data suggested that inflation was basically nonexistent. Of course, this weak TIPS performance followed rallies in September and October as Janet Yellen materialized as the most likely successor to Bernanke for the position of Federal Reserve chairperson. Yellen's aforementioned dovish reputation led investors to buy TIPS with the mindset that inflation was more likely to materialize with her at the helm of the central bank. These recent swings aside, at present, a small position in TIPS seems reasonable to us, and as we move through 2014, an increase to this position may be appropriate.

Equities have long been considered a hedge against inflation. This is only true, however, to the extent that companies are able to increase prices above and beyond rising input costs, such as labor & materials. Failure to do so results in falling profit margins and, all else equal, lower earnings. Rather than relying on a rising tide (inflation) lifting all boats (stocks), we believe that the best equity inflation hedges are those that exploit beneficiaries of specific pockets of inflation present in the economy. This means looking for industries where there are (or will be) meaningful supply-side shortages and/or bottlenecks in the value chain.

Companies favorably positioned in supply-constrained industries stand a very good chance of maintaining (or even increasing) pricing power in the face of rising inflation. Similarly, companies operating in critical areas of an industry's value chain are capable of raising prices above and beyond their input costs, as producers have few (if any) alternative options. We think businesses in positions like these, with the wind at their back, should do well even if economy-wide inflation takes longer than expected to materialize. In this way, investors have an opportunity to not only potentially hedge inflation, but also to get paid to wait.

Oftentimes, the greatest risks (as well as opportunities) in investing emerge from unsustainable trends. The disinflationary backdrop which has existed for years now, despite aggressive monetary policies in the U.S., may be just one such trend. While this trend may not be as extreme as the trends in home prices last decade or tech stocks in the late 1990s, it is certainly one that will have a meaningful impact when it ends.

Up until now, inflation has not been a concern for investors, despite an extended period of very easy monetary policy and a labor market whose convalescent phase appears to be ending. An upside inflation surprise in the intermediate term is definitely in the realm of possibility, and intermediate-term vigilance is warranted. At a time when this is not a concern on anyone else's minds, it may be worthwhile to consider buying insurance against inflation at a very reasonable price.

Source: Inflation, The Forgotten Risk?