Colin Moore explains the current state of inflation, the arduous task of the Fed “getting it right” and why it matters to investors.
You probably know that it’s not a good thing to have too much or too little inflation. But trying to get a huge pendulum the size of the U.S. economy to settle in the middle is very difficult. Here’s a deeper look at the current situation, how we got here and what it all means for both fixed-income and equity investors.
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Earlier this year, U.S. consumer price inflation (CPI) moved above expectations. It heightened the possibility the Federal Reserve may raise interest rates faster than anticipated if the upward trend in inflation continues. The Fed’s preferred gauge of inflation, the core PCE price index, is also inching up. The Fed welcomes the notion of inflation moving upward toward its 2% target, and it’s unlikely that it will be swayed off its course of raising interest rates because of a single inflation reading. But a series of readings above expectations may encourage the Fed to raise interest rates more aggressively.
Consequently, investors have very quickly turned their attention to increasing inflation and the possibility that the Fed may raise interest rates at a faster pace and to a higher level than previously expected.
Inflation affects both fixed-income and equity markets
To understand how inflation expectations affect markets, it’s important to have a conceptual understanding of the methodology behind the composition of bond yields and equity market valuations.
The yield an investor receives on a bond with a 10-year maturity is a combination of five things:
- The current short-term interest rate, determined by the Fed
- Investors’ expectations of changes to the Fed’s short-term interest rate policy
- A premium to compensate for the risk of changes in inflation, which could erode investment values over the lifespan of the bond more than currently anticipated.
- A premium for the unknown risks an investor takes over the life of the bond, known as the term premium. Predicting what will happen 10 years from now is very difficult, so the yield on a 10-year bond tends to be higher than a 2- or 5-year bond.
- The relative attractiveness of other asset classes. Regardless of the sum of the first four inputs, if investors don’t find the resulting yield attractive, they will not purchase the bonds. Yields should rise to reach an equilibrium with investor expectations to attract investors. It could be argued this is covered above, but I think it’s important to isolate this consideration.
If expectations about inflation are changing, then investors face uncertainty in all of the above. The resulting bond yield is also a factor in determining the value of equity markets. Equity market valuation is based on forward-looking assumptions on corporate earnings growth discounted by a combination of long-term bond yields and a premium for the equity investors’ uncertainty compared with the “guaranteed” nominal returns that fixed-income investors receive from U.S. Treasury bonds. This premium is rather unimaginatively known as the equity risk premia. Therefore, given the importance of bond yields to equity valuation, equity investors are affected by potential changes in bond yields just as much as fixed-income investors.
Finding the right level of inflation
Inflation is a tricky issue for monetary authorities and investors. The economy and corporate earnings generally do well in times of moderate inflation because prices and wages rise, but there’s a lag that allows corporate profits to rise first. Too much or too little inflation is a bad thing, but trying to get a huge pendulum the size of the U.S. economy to settle in the middle is very difficult. There are just too many forces to assume the whole system can be stable. It inevitably moves through a pendulum’s swing, requiring the Fed to adjust the level of interest rates.
What are investors’ expectations for inflation?
Investors are clearly expecting inflation to be higher than one or two years ago, but expectations are moderate by longer term historical standards. The drop in energy prices from mid-2014 to early 2016 set inflation expectations back to the levels we saw after the 2008 financial crisis, and it has yet to be fully reversed. I would say current inflation expectations are around position 4 on the pendulum (modest inflation), which is not a particularly troublesome spot for equities. In the current environment, although inflation appears to be increasing, it’s still not likely to cause 10-year yields to rise to levels that would be problematic for equities. I estimate that problematic level to be a 4% yield.
The notion of inflation and rising interest rates has made many investors pay attention — especially given the possibility that the Fed may raise rates higher or faster than we all previously expected. While hitting the right levels of inflation certainly poses a challenge for the Fed, and it will affect both equity and fixed-income investors, it hasn’t reached a level that should be a cause for concern.
Article by Colin Moore, Columbia Threadneedle Investments