INSIGHTS

On October 29, 2018

AAM Viewpoints – Inflation Pressures Are Real & Growing – The Evidence is Overwhelming

Asset Allocation Changes Likely Needed

Unlike in recent years, inflation forces are now truly on the rise and are likely just as hard to stop as they were to start. Ever since The Great Recession, the Federal Reserve (Fed) has been targeting the creation and level of inflation in the U.S. economy. Those who attempted to take advantage of the actions of the Fed have been frustrated, as inflation had not picked up to a sustainable level. Now we are finally seeing substantial evidence that the Fed is getting what it wanted; the year-over-year inflation rate is tracking well above their 2% target and appears to be accelerating. The Fed has spent over 10 years and trillions of dollars buying bonds to get us to that level. Could it be as hard to control inflation as it was to start it?

Several money managers have tried to institute the “reflation trade” since the financial crisis with paltry results. The market has become jaded toward the return of inflationary forces in any great degree. In fact, many believe that inflation is dead, and globalization will keep it that way. However, we believe that although history may not repeat itself, it will always “rhyme” and that the Fed eventually gets what it wants. Instead, we believe that although economic forces can be latent for years, they generally don’t just die. We think the Fed is finally finding traction following their 10 years of planting inflation seeds. Why worry, you ask? Inflation is a good thing in moderation, but it can be very destructive in larger doses and the Fed has a history of being well-behind the curve. The last 10 years have witnessed a Fed that has created tools out of thin air and employed never-before-tried strategies in the United States. Could the consequences be just as large? We think so and we are not alone.

In a recent interview on CNBC (September 18, 2018) Rich Bernstein was quoted with the following comments on inflation:

What the market is missing is that inflation can be good for some asset classes and very bad for others. Inflation has been characterized as “too many dollars chasing too few goods and services.” In essence, inflation is the diminution of purchasing power due to rising prices. During times of inflation, it takes more dollars to purchase goods and services as their prices escalate. Several things contribute to the steadily rising prices, including higher input costs (labor, energy and materials) as well as reduced competition (tariffs) and higher cost of money (interest rates). Once the spiral begins it is often very difficult to stop.

Inflation should re-emerge because global central banks have employed an unlimited amount of currency printing and credit to achieve their inflation goals. The excess currency that has monetized trillions of sovereign debt globally will be in the system for years to come. The amounts of QE (quantitative easing) that continue is indeed record setting. Should you not think that the product of those efforts will be record setting as well?

In a research piece released this month, Morgan Stanley noted that investors should heed the increases in inflation pressures because nobody is taking them seriously. Even former Fed Chair Janet Yellen was quoted last year stating that the lack of inflation in the United States is a “mystery.” Morgan Stanley cited two main reasons for their forecast for an uptick in inflation here in the United States and a more pronounced uptick in the Euro area and Japan. First, they cite wage growth is finally ticking up. Second, they cite a macro backdrop that has changed. They note that since the financial crisis of 2008 that the global economy has been deleveraging. Beginning in 2017 that trend changed to investment demand in capital expenditures. The result is that above trend global growth is drawing down economic resources, pushing up capacity utilization rates and wage growth which will likely be translated into higher core goods and services inflation.

Recent earnings guidance has warned against the perils of higher input costs, potential for tariffs and higher wage pressures. Recently, Walmart and Amazon (two of the biggest employers in the world) announced substantial increases in their respective minimum wages. We posit that the action was done more to keep their employees, rather than show the world that they care to pay a sustainable wage. Recent spikes in job openings (JOLTS) and rising quit rates tend to indicate that employees are voting for higher wages with their feet.

What does this mean for investors? We believe it means that portfolios should be tilted toward sectors that could benefit from rising prices and avoid sectors that will likely suffer from upward pressure on inflation. As mentioned above, Rich Bernstein noted four areas that benefit from inflation: energy, materials, industrials and even gold. We agree. We would also add to that the high correlation of emerging markets to real asset inflation. Many emerging markets are tied to mining, energy and crop exports, whose economies tend to do well when their products are rising in price. We think it is no different this time.

Which sectors tend to do badly when inflation pressures rise? With inflation comes higher interest rates. The two have been tied together at the hip and have followed each other relentlessly up and down. The reason is that expected levels of inflation or deflation have a direct impact on interest rates. When inflation expectations rise, lenders factor currency purchasing depreciation into loans with higher interest rates to cover the loss of purchasing power from the time the money is loaned to the time it is repaid. Likewise, when inflation expectations sink lenders respond by removing interest designed to reflect a lower loss of purchasing power. Central banks can control the interest rate markets for years, but sooner or later the markets will take over pricing. We think that central banks are now looking for the exit and market forces will not be a bond market’s friend. Rising inflation equals a headwind for bond holders. Recent record inflows into fixed income at a time when expected returns are the lowest on record may end up hurting those who thought bonds were the safe bet.

I have learned during my three decades in the business that you should never fight the Fed. If the Fed is intent on creating inflation, then they will use every tool they have to pursue it and will not stop until achieved. A very well-defined 10-year Treasury yield channel that has recently, and very decidedly, been broken. This is a confirmation for us that higher interest rates and inflation are on the way.

Other areas that suffer with inflation are industries that cannot easily raise prices on their goods and services or operate on very thin margins. These industries are generally manufacturing-based where input prices and consumer demand dictate their profitability. Think automobile manufacturers who began to complain about input prices rising back in the spring. Their inability to raise prices for the consumer against rising input costs suffocates profitability.

Finally, companies that rely on significant amounts of leverage in their business models often find higher inflation and interest rates take a bite out of their profits. Companies such as utilities, REITs (Real Estate Investment Trusts) and over-levered corporations will experience profit compression as their cost of leverage moves up. The offset is to raise rents and rates they charge to consumers. If they can’t pass those higher borrowing costs on in the form of higher rates, rents or prices, they too will have a profit suffocation.

Our conclusion is clear: investment models need to be adjusted to accommodate higher rates of price inflation in the future. We know of no models today that adequately do that as most have been formulated during a time when disinflation was the macro move. In fact, most advisors, portfolio managers and traders have never experienced a time of rising inflation. It is time to get educated as the investment playbook is changing.