What Are Investors Overlooking? It Could Be Higher Inflation by Vinod Chathlani

Conditions seem ripe for higher inflation in some developed countries, but markets have yet to price this in. It may be time for investors to consider how rising prices would affect their portfolios.

Slow nominal economic growth across the world has kept core inflation, which strips out volatile food and energy prices, low in recent years—despite the best efforts of central banks to nudge it higher. But we think conditions are starting to change, and a confluence of cyclical factors and policy considerations could lead to higher inflation in some economies.

The cyclical factors are most obvious in the US, where a tightening labor market is starting to put upward pressure on wages (Display 1). The gap between the current and natural unemployment rates has narrowed considerably in recent years. In the past, such a trend has led to steadily rising wages, which usually end up pushing prices higher throughout the economy. We’re starting to see signs of that now. Also, wage growth tends to be closely tied to services inflation, which dominates the aggregate US consumption basket.

Inflation

At the same time, the US dollar, which rose sharply last year and helped suppress inflation by lowering import prices, has come back down to earth in 2016 (Display 2). We don’t expect the dollar to rise quite as aggressively in the near future, now that the Federal Reserve looks unlikely to deliver multiple interest-rate hikes this year. In fact, the uncertain path of global growth probably means rates will remain low for some time.

Inflation

Fiscal Policy In Focus

In Europe and Japan, inflation is still negligible. But that may change if policymakers start using expansionary fiscal policy to help jump-start economies that haven’t responded to central banks’ aggressive quantitative easing and negative-interest-rate policies.

The timing is right for this type of approach; fiscal policy tends to be most effective when an economy is operating below capacity and monetary policy has been stretched to its limit. Both of these conditions are in place today. A boost from fiscal spending could help the economy break out of its low-growth cycle by raising aggregate demand and inflation. We view Japan as being closest to implementing such a policy.

Markets Slow To Price In Higher Inflation

These developments don’t guarantee inflation will surge overnight. But we think they do make a surprise increase in inflation a bigger risk for investors than a further decline.

A big reason for our concern is that investors have yet to start pricing these risks into the market. Expectations of future inflation—based on surveys of US households, businesses, and economists as well as market-based measures of inflation compensation—have remained low (Display 3). Most don’t expect to see inflation rise above the Fed’s 2% target anytime soon.

Inflation

The disconnect among recent data trends, talk of fiscal policy expansion and modest inflation expectations increase the risk of sudden market dislocations that could catch investors off guard. Both stocks and bonds tend to struggle when inflation runs ahead of expectations.

Time To Inflation-Proof Your Portfolio?

It may make sense for investors to take a fresh look at their portfolios’ inflation sensitivity, which is also known as inflation beta. For those who don’t already have inflation-sensitive assets in their portfolio, now may be the time to consider adding them.

In our view, a dynamic, well-constructed multi-asset approach offers the most effective way to do that. For starters, it widens the opportunity set by letting managers go anywhere in the global capital markets to find inflation-sensitive assets that would benefit from a reflationary environment. Some examples might be commodities, real estate equities, currencies or global inflation-linked bonds.

A strategy that can move seamlessly across asset classes and regions also lets managers see how the various pieces of an allocation fit together. That makes it easier to add inflation-sensitive real assets in a way that complements other portfolio components.

Hedging against any risk is best done in advance. The good news in this case is that it shouldn’t cost much. Because markets aren’t focused on inflation at the moment, insurance against higher inflation is still cheap.

It may take time for inflation to move higher. But we think the conditions for rising prices in the developed world are starting to fall into place. If you’re a long-term, outcome-oriented investor, now may be the time to act.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.