by Umar Farooq
2017 kicked off with a reflationary revival as the consumer price index (CPI) recorded 2.5% year-over-year (YoY) growth in January – Its highest reading since early-2012. Inflation has been trending upward since 2015, but its upward slope has only come to the forefront since the election. Although the current inflation rate is low in a historical context, its return has widespread effects. It’s critical to understand that inflation isn’t a switch that is flipped on and off. Certain goods, companies and asset classes are affected very differently. That means before you go all-in on popular inflation hedges, you need to take a deep breath and look at the details.
The rise in inflation looks to be positive for economic growth. Growing inflation has caused bond yields to rise. The 10-year Treasury yield, which moves inversely to its price, is up 45% since July. The bout of reflation has given equities a boost. From 1973–2016, equities performed best when inflation was running between 1–3%. Since July, the S&P 500 and the Dow Jones Industrial Average (DJIA) are up 6.5% and 8.6%, respectively. Wage growth, long missing in the post-crisis recovery, is back. Average hourly wages were up 2.5% YoY in January. Rising incomes are possibly the most important aspect of this reflationary move. The self-reinforcing dynamic of higher earnings feeds inflation and helps consumer demand. An increase in labor costs could weigh on corporate profits. However, with margins near all-time highs, companies have the ability to absorb greater input costs. In the last 3 periods of reflation, corporate profits and salaries have moved higher in tandem.
Treasure Inflation Protected Securities are the go-to investment for many. And why wouldn’t they be, with the principal value of TIPS increasing as inflation heats up? However, it’s important to keep in mind that while the latest $7 billion offering of 30-year TIPS featured the highest yield in roughly a year, the 0.923% yield is still painfully small.
One of the hottest areas of inflation is in the real-estate market. This is thanks to a convergence of factors, including a better job market and easier access to credit fueling demand and tight supplies in many markets. November’s S&P/CoreLogic Case-Shiller numbers released in January showed a 5.3% annual gain in home prices among its 20 major metro areas, with the weakest region (New York, if you’re curious) reporting a 12-month growth rate of 2.4%. The supply-demand dynamic doesn’t seem to be fading, either, with the National Association of Realtors reporting a big jump in existing homes sales for January that puts sales at their strongest level since 2007.
On the plus side, that volatility seems to be working in gold’s favor right now with gold prices are up more than 10% since their December lows in a nearly constant upward trajectory. That’s partially because of inflation fears, but also partially because of geopolitical uncertainty around the globe. However, as with TIPS, it’s important to remember that gold might not remain in favor if we see a material rate hike. Higher interest rates would not only cool off inflation, but also drive nervous investors into T-notes instead of gold.
Energy and base metal stocks
Of course, while the threat of inflation may be propping up gold, not all commodity prices have been moving to the upside. Consider that while gold is up more than 8% since Jan. 1, oil prices have actually rolled back about 3% since the start of the year. This downside momentum is worrying, but equally worrying should be some base metal stocks that have surged on the hope that President Donald Trump will help them with better trade deals and regulation. With U.S. Steel up about 90% since Election Day, it’s basically priced for perfection.
There’s plenty of market uncertainty out there, but 2017 also is characterized by uncertainty about the Fed, and about the prospect of trade wars and tariffs in a tumultuous Washington environment. So it’s nice to have the certainty of health care to fall back on.
In short, with a 2.5% CPI figure, gone are the days when earning 2% returns would have kept you above water. Creeping inflation is a greater concern for the non-investor than investor. Your money must be put to work, or your wealth will be eroded in real terms.
by Umar Farooq