Trumpflation Risk: What You Need to Know

Does Donald Trump’s election victory mean that US investors should brace for higher inflation? Financial markets certainly think so. It may be time for investors to take note.

Of course, conditions were ripe for higher inflation even before the US election. In some developed economies, inflation potential has been building for a while. But financial markets have taken their time pricing it in.

That changed after Trump’s election on November 8. Inflation expectations have since surged, and it’s not just one indicator pointing the way. Market-based measures of inflation compensation clearly indicate that investors expect prices to rise. Meanwhile, stock markets and the dollar have rallied while global bond markets have been under steady pressure—longer-term US Treasury yields spiked by nearly 40 basis points in the week after the election.

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Three Things That Could Drive Trumpflation

Of course, what Trump will do as president isn’t certain. But if his core policy proposals were to become law—and with Republicans in control of Congress, there’s a decent chance some will—we’d expect inflation to rise. Here are three ways Trump’s policies could heat up prices:

Huge infrastructure spending, lower taxes, simpler regulation: This mix would stimulate real economic growth. But it would also stimulate higher prices, swell the deficit and drive interest rates higher.

Clamping down on free trade: Tearing up existing trade agreements, as Trump vowed to do during the campaign, would raise trade barriers and tariffs that would likely lead to an increase in the price of imported goods.

Hitting the brakes on immigration: Any limits on the flow of immigrants would slow growth and create bottlenecks in an already tight labor market. Tighter labor conditions put upward pressure on wages, a key inflation driver.

All three of the factors listed above are likely to be inflationary, but only the first would be bullish for economic growth. The other two factors could actually slow growth, and a mix of higher inflation and slower growth would likely cause companies’ costs to grow more quickly than revenues, squeezing profit margins (Display 1).

Since there’s potential for one or more of these factors to come into play, investors who don’t already own inflation-sensitive assets might want to consider adding them.

Too Much Concentration Within Inflation-Sensitive Assets?

But how they add these assets can make a big difference—betting too heavily on any one asset can lead to trouble. For example, many investors reacted to Trump’s surprise win by pouring money into Treasury Inflation-Protected Securities (TIPS). On the surface, this seemed logical. After all, TIPS are indexed to inflation, so their face value rises as inflation does. In other words, more inflation means a bigger bond.

But many people overlook the higher interest-rate risk of TIPS, which can offset those benefits. The TIPS market had an average duration of 8.1 years through October 31, compared to 6.4 years for the US Treasury market and 5.5 years for the broader US bond market. The higher the duration, the more sensitive a bond is to changes in interest rates. Bonds with higher durations do well when rates fall, but not when rates rise. And if there’s one thing inflation almost guarantees, it’s higher policy rates.

Don’t Forget to Diversify

To avoid these pitfalls, we think it makes a lot more sense to access a wide range of inflation-sensitive assets globally with a diversified, multi-asset approach. This type of strategy can supplement some TIPS exposure with positions in other assets that stand to benefit from renewed aggregate inflation: commodities, currencies, and natural-resource and real estate stocks, to name a few.

At times, though, prices rise in some areas and fall in others, causing some parts of the basic consumption basket to inflate while others deflate. Over the last couple of years, for example, energy prices have fallen even as rents, tuition costs and healthcare prices have risen.

A holistic, multi-asset strategy can look under the hood and pivot toward assets that are best positioned to benefit from inflation where it exists. That can require drilling down into the fundamentals of specific companies. For example, a pharmaceutical company with a stronger patent pipeline than its peers have would be better positioned to capitalize on rising healthcare prices, which should support its margins.

Despite the sharp moves in the last couple of weeks, we think inflation-sensitive assets are still attractively valued (Display 2). In other words, the cost of buying inflation insurance is still low.

With the US possibly on the cusp of a new era of tax cuts and aggressive public spending—and with the potential for more monetary and fiscal stimulus elsewhere in the world—we think it makes sense to vote for inflation protection.

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.