Expect The Unexpected: Inflation

by: Invest With Discipline
Summary

There are several catalysts poised to stoke inflation much higher than market participants expect.

Investor portfolios likely benefited from recent moderation in inflation over the past several months, primarily from significant contraction in long-term bond yields.

Many popular investments have a negative correlation to unexpected inflation.

Now is an ideal time for investors to reevaluate the embedded risks that stem from unanticipated inflation growth.

Investment Thesis Overview

[source: Bureau of Labor Statistics]

One of the primary themes in 2019 has been the lack of inflation growth. Some investors point to the Fed as too restrictive in its monetary policy. Others will justify it is because of structural issues with demographics and the economy. However, most investors disregard any potential stemming from an increasingly inflationary environment, as highlighted by breakeven expectations:

[source: Federal Reserve Bank of St. Louis]

Though moderate inflation is healthy for the economy, and therefore benefits most investment portfolios, an unanticipated jump in inflation above expected levels could have negative consequences. Investor portfolios could be at risk if not properly allocated to mitigate this potential scenario.

The following report will highlight several potential sources of increased inflation and the likely investment implications that would ensue should inflation rebound accordingly. Because disinflation has been a main catalyst with investment returns over the past several months, investor portfolios might have evolved to a place where risks associated with an increasingly inflationary environment greatly outweigh risks associated with a stagnant or disinflationary environment. Therefore, it is prudent to reevaluate portfolio allocations, even if higher inflation is not of great concern currently.

Potential Sources of Inflation

Trade War / Tariffs

On May 10th, U.S. Trade Representative Robert Lighthizer released a statement confirming President Trump’s direction to increase China tariffs from 10% to 25% on approximately $200b of Chinese imports. Shortly thereafter, U.S. officials threatened tariffs on another $300b worth of Chinese imports. Based on reports, the plan is to finalize the comment period prior to the G20 leaders summit at the end of June, as President Trump will likely meet with Chinese President, Xi Jinping, at this point before confirming his decision. The proposed list of new tariffs would cover most consumer products imported from China that are untouched currently.

Though focusing on the politics (and accompanying speculation) that results from this trade dispute is primarily covered on mainstream media, the discussion for investors should be geared towards the likely investment implications that could ensue from increased tariffs: inflation. The basics of tariffs suggest that imported goods become more expensive based on the levied tax applied from the domestic government. Typically, importers will “pass along” that tax to consumers in the form of increased (“inflated”) prices for those goods. If domestic companies are unable to provide the same sort of product at a price similar to the current level, then inflation measures should start to climb higher, especially for goods that are minimally discretionary. Furthermore, ocean tides tend to lift all boats, so it is perceivable that tariff-based inflation could have corresponding effects on products and services outside of Chinese imports.

The degree to which U.S. officials decide to impose tariffs is pure speculation, at this point. However, investors should be thoroughly cognizant of the inflation ramifications that could follow should the U.S. continue to implement increased tariffs.

Employment Levels / Wage Growth

One of the greatest unsolved mysteries of late is the lack of inflation that typically corresponds to a strong labor market. As shown in the graph below, when employment levels are high, inflation starts to climb higher as consumer demand pushes prices of goods higher (ie. demand-pull inflation).

[source: Bureau of Labor Statistics]

This investment principle is referred to as the Phillips Curve. The theory suggests that high employment rates lead to increased wages (in order to retain and attract talent), that then leads to increased consumer spending. It is this jump in demand that allows companies to increase prices of its respective goods and services, thus growing inflation metrics. Unfortunately, the past couple of years have proven otherwise, as wage growth metrics have been lackluster even though employment rates were high:

[source: Bureau of Labor Statistics]

Though wage growth has been muted, it is starting to slowly show gains in recent past. From the beginning of 2014 to the end of 2017, wage growth hovered around 2% with very little volatility. However, since the beginning of 2018, wage growth climbed significantly higher to a level near 3.5%. The effects on inflation due to wage growth take several months to develop, if not longer. Therefore, inflation could start to tick higher as consumer spending increases from healthier incomes:

[source: Bureau of Economic Analysis]

Furthermore, if the economy continues to expand, especially near a 3% rate as indicated by 1Q19 GDP, it should be assumed that wage growth will continue to strengthen, particularly since employment metrics are near maximum capacity. As explained by the Phillips Curve theory, increased wage growth should result in stronger inflation via increased consumer spending:

[source: Bureau of Economic Analysis]

Money Supply

[source: Federal Reserve Bank of St. Louis]

Another factor that has led to muted inflation over the past several years is the lack of velocity in money supply. As the above chart highlights, money has been exchanged at a decreasing rate since the Great Recession, and currently resides at a level well below its 50+ year average. Though this explains why inflation has been consistently low for the past several years, it does not forecast the future. In fact, this backwards-looking data point could suggest that the velocity of money might be bottoming out. Many economists propose that structural aspects of our economy have led to current, depressed levels in the velocity of money. However, it seems reasonable to conclude that the material risk is unexpected increases in money supply, thereby pushing inflation higher.

One of the Federal Reserve’s objectives is to control money supply. Since it currently paused its rate-hiking cycle, any accommodations from the Fed could propel this velocity data upwards. Per the CME Group, market participants are pricing in a 95% probability of at least one rate cut by year-end. Though probabilities can fluctuate quickly, it is clearly evident that the market expects the Fed to be more accommodative in some fashion, which could increase money supply levels and ultimately inflation.

National Debt

[source: Congressional Budget Office]

The level (and growth) of national debt has direct implications on inflation, albeit over the long-term. When governments increase debt levels, they typically have two options to service that debt: increase taxes or print more money. Both result in increased inflation. Hiking taxes would incentivize companies to increase prices in order to sustain profit margins, all else equal. As previously discussed, printing more money (ie. increasing the supply/velocity of money) should result in increased inflation. Though current and expected debt levels would suggest higher inflation, this factor may not be an immediate concern for inflation expectations. However, policies can change quicker than expectations and investors should keep a keen eye on this factor, nonetheless.

Commodity Inflation Rebounding

As previously mentioned, the old adage that an ocean tide lifts all boats could be applied with commodity inflation, which is referred to as “cost-push inflation.” Most economists and market participants focus on the “core” rate of inflation, that excludes food and energy, as these two sectors can be quite volatile each month. However, their effects on the overall economy remain intact, and can cause other sectors to adjust accordingly. The chart below presents CPI for three different sectors: energy, food, and all other commodities. As shown, the current valuation of commodities remains depressed; however, growth in food and energy prices puts upward pressure on other commodity prices. As discussed with the velocity of money, the risk in commodity prices seems to be skewed towards potential upward surprises. Therefore, it should be assumed that overall stagnant inflation should not be supported by lower commodity prices moving forward.

[source: Bureau of Labor Statistics]

The previously discussed list of potential inflation sources does not cover all potential catalysts. However, these seem to be the most significant sources that could have a material impact on future outsized increases in inflation. The biggest theme with all sources discussed above is the fact that most data seems to be exaggeratedly low and explains why inflation has been lackluster. It is difficult to predict with certainty that these measures will rebound substantially. But projecting current inflation data forward could lead to serious issues in both the economy and within investment portfolios.

Investment Implications

If inflation does start to unexpectantly climb higher, and at a quicker pace than most anticipate, investors should be well informed of the potential investment implications within their portfolio. Please note, the following discussion pertains to unanticipated inflation that exceeds market expectations. Moderate inflation, that is well predicted, typically has a positive impact on most investments.

Significant Increase In Long-Duration Yields

This is the most important implication, as the yields on long-duration bonds (ie. 10-year Treasury) have strong correlations to the level of inflation, as highlighted below:

[source: Bureau of Labor Statistics, market data]

If long-duration yields began to climb substantially higher, investments with strong correlations to duration will likely suffer. These include REITs, utilities, preferred equities and long-duration bonds. Though this list is not all-inclusive, these are by far the most popular investments within portfolios that have strong correlations to duration. To highlight this robust relationship, the two charts below present investor returns when the 10-year Treasury yield increased from 1.70% to 3.00% (May 2013 to January 2014), and again from 1.40% to 3.25% (July 2016 to November 2018).

There are sector-specific factors that will additionally affect the performance of these investments; however, it is quite clear that duration has a materially negative impact on investor returns should the yield on the 10-year Treasury increase drastically and quickly. If investors are concerned about inflation climbing higher, reevaluating their allocations to these types of investments would be advisable.

Rising Cost of Debt

Since increasing inflation would likely cause yields of all maturities to climb higher, the cost of debt could become an issue. Companies with strong balance sheets should have minimal effects from an increased cost of debt. However, lower quality companies would likely suffer from increased financing costs. Investments of such companies primarily include high yield bonds (and related strategies). If the cost of debt increases, the ability of these companies to service its debt (and future obligations) would become more uncertain. In addition, duration risks could compound negative performance from these types of securities. Furthermore, if the economy starts to struggle alongside an inflationary environment with rising interest rates, high yield bond performance could substantially decline due to credit spreads widening.

Equity investments in low quality companies should also suffer from increases in the cost of debt, all else equal. However, if the economy continues to grow, stock beta could keep performance positive as investors expect sustainable profitability. Therefore, further due diligence within specific equity investments would be required prior to assuming negative future performance.

Margin Compression

If unexpected inflation does arise, the likely immediate impact on the stock market would be margin compression within the underlying companies’ financials. Most businesses are hesitant to instantaneously pass inflation through to consumers via price increases in its products or services. Such a process could stifle demand and deter the consumer. Therefore, investors should anticipate contraction in profit margins should inflation climb higher, as expenses rise without subsequent equal increases in revenue. Hopefully this is only a short-term consequence, as businesses slowly adjust their operations to account for such inflation over longer periods of time. Furthermore, companies that can pass inflation through successfully via price increases without deterring the customer should remain on solid ground, relatively speaking. These types of companies typically reside within the consumer defensive sector of the market, as their products and services are non-discretionary.

Business Spending Tightens

Another potential negative impact for equity owners could stem from businesses tightening up investment spending from inflation uncertainty. If business owners anticipate negative consequences from higher inflation (primarily, the inability to immediately pass it through via price increases), business owners might cut costs and/or limit capital allocations in order to maintain profitability. Though this could provide short-term benefits to shareholders, the long-term effects for both shareholders and the economy would be detrimental.

Investments with Positive Momentum

There are some investment vehicles that provide positive correlations to unexpected inflation, including floating-rate securities, TIPS and commodity funds.

  • Floating-Rate Securities. If inflation propels upwards, the Fed will likely increase its Fed Funds rate in order to mitigate hyperinflation. Such increases in interest rates are the primary investment catalyst for floating-rate securities. Performance within this sector should only occur while the economy continues to grow, though. A slowdown in the economy, even if only perceived, will negatively impact floating-rate securities due to their low credit quality. Such effects should materially outweigh the positive correlation to higher interest rates. Therefore, keep an eye on credit spreads and try to minimize overallocations when spreads are very tight.
  • Treasury Inflation Protected Securities (OTC:TIPS). This investment vehicle should outperform similar investments (ie. Barclays Aggregate Bond index) during an inflationary environment. However, most strategies still encompass duration which should detract from returns. Therefore, investors would likely benefit more from short duration strategies, such as the iShares 0-5 Year TIPS Bond ETF (ticker: STIP).
  • Commodity Funds. Most commodities have a strong correlation to inflation. However, not all commodity strategies are created equal, nor are the underlying commodities themselves. Therefore, further due diligence is required to find an appropriate strategy, as other factors outside of just inflation would impact performance, as well. Plus, there are idiosyncratic aspects to investing in various types of commodities that warrant a much greater discussion.

Investors that want to prepare for unexpected inflation could look towards these investments to help diversify their portfolios and limit corresponding risks. Furthermore, increasing allocations to short-duration bond funds can also be advantageous during an inflationary environment. Not only would these investments benefit from potential increases in the Fed Funds rate (as the Fed tries to control inflation), but they act as an attractive cash alternative until other opportunities present themselves.

Closing Thoughts

Based on current levels of inflation, and corresponding valuations of associated investments, inflation surprising to the upside would likely have detrimental effects on most investor portfolios – at least those portfolios that are not adequately prepared. In addition, significant unexpected inflation could cause the economy to rollover, even if not considered a hyperinflationary environment. Most market participants expect inflation to be low for longer, as highlighted by the market’s probability of rate cuts. Therefore, a slight increase of inflation expectations above the Fed’s 2% threshold could cause significant ripple effects throughout capital markets. Though increased inflation does not seem to be a forecasted issue throughout the industry, it might be prudent for investors to start preparing for this potential portfolio risk, nonetheless.

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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.