Seeking to identify near-term risks to the U.S. economy and its financial markets, the Janus Asset Allocation Team noticed that the prospect of an acceleration in inflation has been largely absent from the conversation. In our view, this omission is a mistake.
We first noted this risk late last year when we cautioned that unit labor costs appeared set to rise. When we published our Janus Market GPSTM in January, we believed the low unemployment rate inferred a tight labor market for the most productive workers and that any future employment gains would likely come at the expense of diminished productivity.
The view was outside consensus forecasts at the time, but now our proprietary model indicates that financial markets reflect the possibility that a long-delayed upward move in prices may be on the horizon. Our option-based model was designed to provide insight into which asset classes and sectors are best positioned to weather such an environment.
Given the extended period of stubbornly low price pressures, we believe investors may want to consider preparing for a long-delayed uptick in inflation. Of primary importance is identifying the specific sources of rising prices and how they will reverberate through the real economy and financial markets.
A transfer from monetary to fiscal stimulus?
In addition to tight labor markets for skilled workers and an expected resultant uptick in wages, upward price pressure may also stem from the expansion in the money supply in the years since the Federal Reserve (Fed) launched its quantitative easing program. The surge in the money supply has - up to now - failed to cycle through the economy, as evidenced by historically low velocity. We believe that this will change, and that the catalyst will be the wave of fiscal stimulus.
Both major party nominees for the U.S. presidency have hinted at their preference to increase public spending, especially on infrastructure. We believe that whoever wins November's election, he or she will inherit the traditional "honeymoon" period in early 2017 - lasting perhaps as long as six months - when Congress will defer to the administration's agenda.
The Fed has long championed fiscal stimulus as a necessary complement to its accommodative monetary policy. At this stage of the economic recovery, we believe a hand-off from monetary stimulus to fiscal stimulus would support growth and enable the Fed to gradually normalize monetary policy through incremental rate hikes.
We consider fiscal stimulus an effective tool to reflate the economy, especially given our view that the most recent iterations of expansive monetary policy resulted in diminishing returns. Rather than reigniting the "animal spirits" of the U.S. economy, low rates largely created an environment conducive to financial engineering. Companies, to a degree, used favorable borrowing conditions to re-lever balance sheets to boost earnings rather than invest in new projects.
Fiscal stimulus, in our view, would have a more direct impact on the real economy, putting people to work on infrastructure projects and increasing government expenditures across a range of channels. We feel the end result would be an increase in demand-pull inflation, especially as longer-duration initiatives would entice both consumers and companies to spend their income gains rather than save them.
This demand-pull driver combined with the cost-push inflation driven by tighter labor supply and the recent reset of commodities prices to a higher range creates an environment where inflation is a very real possibility, which ironically is largely ignored by the market.
Monetary policy still has a role
We believe the prospect for rising inflation reflected in our models is largely premised on a political climate that may be more conducive for fiscal stimulus. In order to keep aggregate price gains on the 2% track, the hand off between monetary stimulus and fiscal stimulus must be seamless. Otherwise, one downside risk we foresee is the threat of stagflation, inflation driven by cost-push pressures with no increases on the demand side.
Outweighing these risks is the opportunity for the Fed to raise rates to a sufficient level so it once again has monetary capacity to combat any future economic downturn. The global economy would, in our opinion, reap benefits as well, especially emerging markets.
These countries are major sources of the products that would see an increase in demand from a healthy U.S. consumer. And amid all these positive potential right tails, the power of security selection will return, unlocked by the normalization of rates. Economics and fundamentals will ultimately win.
Dissimilar sectors react differently when inflation hits
Although stocks are setting record highs, the recent gains have been concentrated in so-called bond proxies. Should inflation materialize, we expect some of these dividend payers to quickly fall out of favor, as bond proxies are far less attractive as inflation pushes interest rates higher. Additionally, rising labor costs - a key source of inflation in service-based economies - can weigh on earnings.
Finally, despite the promise of higher net-interest margins, it is far from certain that higher interest rates will be the cure-all for the financial sector. In fact, our model indicates that the market does not favor financials. This, however, may be due to the onerous regulatory regime imposed upon the industry in the wake of the financial crisis.
On the other hand, demand-pull inflation should benefit consumer discretionary names as workers are incented to spend. Materials and energy firms should also effectively manage cost-push inflation, especially following the recent uptick in commodity prices.
Should their costs remain stable, these industries stand to improve margins as customers should be more willing to absorb price increases Value stocks, in our view, may get a reprieve from servicing their large debt loads as higher inflation eases their real repayment burden. Technology companies and industrials exposed to government-sponsored infrastructure projects should also reap benefits from fiscal stimulus initiatives.
Industries immune to the possibility of approaching inflation include healthcare and staples, which can pass higher prices onto their customers to maintain their profit margins. While several sectors stand to benefit, our model has yet to substantially upgrade its aggregate view of equities. We still see risks, but our outlook is improving, if only because after several years, companies may be able to confidently raise prices, thus spurring top line growth.
In fixed income markets, we see risk in holding duration. The increase in fiscal stimulus that would give the Fed cover to raise rates, will likely lead to investors rapidly exiting the most interest rate sensitive segments of their bond portfolios.
Janus' asset allocation model indicates that an increase of core inflation toward its targeted range of 2% to 2.5% would alter the prospects for many financial market sectors. Certain business models may be better positioned to adapt to rising prices while others - including some currently in favor - would face significant challenges. As a result, we feel active strategies based on security selection are best suited to navigate through such an environment.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
Additional disclosure: The views presented are as of the date published. They are for information purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security or market sector. No forecasts can be guaranteed. The opinions and examples are meant as an illustration of broader themes, are not an indication of trading intent, and are subject to change at any time due to changes in market or economic conditions. There is no guarantee that the information supplied is accurate, complete, or timely, nor are there any warranties with regards to the results obtained from its use. It is not intended to indicate or imply in any manner that any illustration/example mentioned is now or was ever held in any Janus portfolio, or that current or past results are indicative of future profitability or expectations. As with all investments, there are inherent risks to be considered. In preparing this document, Janus has relied upon and assumed, without independent verification, the accuracy and completeness of all information available from public sources. This material may not be reproduced in whole or in part in any form, or referred to in any other publication, without express written permission. Janus is a registered trademark of Janus International Holding LLC. © Janus International Holding LLC. Janus Capital Group Inc. is a global asset manager offering individual investors and institutional clients complementary asset management disciplines. Janus Capital Management LLC serves as investment adviser. Janus Distributors LLC 151 Detroit St. Denver, CO 80206 FOR MORE INFORMATION CONTACT JANUS 151 Detroit Street, Denver, CO 80206 / 800.668.0434 / www.janus.com C-0816-3421 10-30-16 666-15-43421 07-16