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2018: The Year Inflation Re-Emerges?

| January 19, 2018

Following the financial crisis, the U.S. economy has experienced a long recovery with a noticeable absence of price inflation. Last year, the unemployment rate in the U.S. continued to fall, from 4.8% in January to 4.1% currently. Yet this tight labor market hasn’t resulted in noteworthy increases in wages, and inflation remains below the Federal Reserve’s 2% target. This year, however, may be different, and investors should give some thought as to how well their portfolios are prepared for higher inflation.

The argument in favor of inflation seems fairly straightforward: the economy is already relatively strong and labor markets are tight; Add in the stimulus from the tax reform bill, and you have a pretty good recipe for higher wages and prices. As the new tax withholding tables are put into effect and workers have more after-tax income, the economy should get a boost from increased consumption. The return and reinvestment of corporate capital – both as a result of lower taxes and the repatriation of assets held abroad – will add further stimulus.

While this line of thinking appears solid, there are several reasons to be skeptical. Economists have been anticipating higher inflation for years, and have been consistently wrong.

One reason why inflation may remain contained is that expectations for growth are already getting baked into economic metrics. The markets have been discounting good news for much of the past year. These positive economic surprises will be harder to reproduce in 2018. As yesterday’s surprises become tomorrow’s settled expectations, we may be faced with less favorable data points, and inflationary pressures may cool.

A separate argument for subdued inflation comes from noted economist and manager Gary Shilling who believes that headline unemployment will remain low but will not lead to wage growth. He argues that the decrease in the unemployment rate stems from lower labor force participation rather than the increase in people finding jobs. Labor force participation was over 67% in 2000, but is lower than 63% today. According to Shilling, “Without this precipitous drop in the [labor force participation] rate, the headline unemployment rate, now at 4.1%, would be in double digits.” He points to tight labor markets around the world that exhibit low unemployment alongside low levels of wage and price growth.

Whether inflation does emerge in 2018 is important for several reasons.

First, an increase in wages adversely affects corporate profits since the cost associated with salaries and wages is often one of the largest expenses for companies. At this time, forecasts of company profitability are generally on the rise, but if wages increase, this trend could falter.

Additionally, higher inflation generally results in an increase in interest rates. As it relates to corporate borrowing, higher rates can choke off economic growth as the cost of capital increases for businesses. Families and individuals would find it more costly to take out a mortgage or other consumer loan, so private capital expenditures would decrease. For investors, higher interest rates make fixed income assets more attractive so investment capital may flow away from riskier assets to the safety of bonds. This would mean decreased investor demand for equities and such a move could jeopardize the current stock market rally.

Perhaps most importantly, there could be a pronounced effect on investor psychology. Nine years of a low inflation environment can instill a certain sense of complacency. If investors wake up to find that the ‘new normal’ has been upset, panic-induced capital movements are a possibility. In this way, inflation may present a higher likelihood of tail risks for the markets.

Inflation is a primary macroeconomic factor that should be considered when constructing any strategic asset allocation plan. In 2018, portfolio positioning with respect to this factor may be more significant than in past years. Investors that haven’t done so should review their portfolios, and consider how their different positions might respond if inflation either overshoots or undershoots expectations. At a minimum, this will help investors understand their exposure and sensitivity to inflationary forces.

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