Market Commentary

Inflation: Comeback Conditions Set

July 2014

"If you do not expect the unexpected you will not find it, for it is to be reached neither by search or trail.." – Heraclitus

While investors tussle in differences of opinion over many things, they don't seem to currently tussle much over inflation. Conventional wisdom has it that inflation has gone dormant or is dead. Reasons usually given for this are some combination of productivity gains wrought by blazing technological change, the globalization of capital, ideas, and people, as well as continued and necessary deflationary fallout from the financial crisis and the great recession.

Our opinion is that could shift in the coming months. This shift, not widely expected, could create some dangers and opportunities in the markets and with your investments, and we think is worth some elaboration.

In the years following the financial crisis, interest rates have stayed at or near zero to accommodate an economy where fear had become profound, transactions were fewer, and policymakers sought restoration of confidence. In addition, the Federal Reserve has widely and publicly manipulated large swaths of our fixed income markets by itself buying new-issue Treasury and mortgage investments, essentially printing money. Some of this accommodation we feel was necessary to grease the wheels of a system suffering a deep lack of confidence. Over the past six years, confidence in many aspects of the financial system has been restored, and we again see pre-crisis-like activity in the commercial and consumer credit, stock, and housing markets. There has been rather aggressive asset inflation in the stock and real estate markets of late – witness recent stock market performance, or listen to someone trying to buy a house in San Francisco this past spring and you get the picture. Though price increases may not be as noticeable on our everyday purchases, financial and real asset prices have moved up markedly. This was a goal of monetary policy coming out of the great recession: restore confidence by raising the price of financial and real assets.

Time to sound the all-clear, right? Well, we haven't. While the Federal Reserve is following a gradual deceleration of asset purchases, known as its 'taper,' it has announced that it won't really be considering raising interest rates for at least several more quarters. The Fed has also telegraphed recently that it views asset bubbles as irrelevant to its policies – something we consider with skepticism after experiencing credit-fueled booms and busts in 2000 and 2008. We note that currently there is three times the amount of money in circulation than there was in circulation before the financial crisis began in 2008. We've recently seen signs of faster movement of this money: household credit has begun to expand again, rather rapidly, and businesses are borrowing money hand over fist, sometimes to purchase their own shares in the equity markets. Credit standards have loosened again over the past six months in the housing and consumer credit sectors. While the economy is growing slowly, parts of the economy that rely on credit expansion, like auto sales and their accompanying loans, are growing quickly. The price of oil has risen sharply this year, partly in response to specific global crises like Iraq, and sustained oil price increases are clearly additive to inflation in a world so heavily reliant on carbon-based energy. Finally, even as we know the Consumer Price Index is a flawed indicator of inflation, in fact deeply so, the most recent monthly readings show the possibility of an inflationary spike developing by the end of the year.

How to invest for this eventuality? We have targeted your portfolio allocation to get through a change in expectations around inflation, as well as positioned to take advantage of opportunities that may develop.

On the fixed-income side, your bond positions are short in duration and not exposed significantly to changes in expectations on interest rates, because as surely as inflation comes, changes in expectations on interest rates will follow. Currently your shorter positions are focused more on taking reasonable credit and currency risks, which we think will work usefully for you until we see better opportunities on the interest rate spectrum. Some of this fixed income allocation, while shielded from excessive interest rate risk, could be deployed at the right price to invest in more inflation-friendly equity investments at good valuations.

On the stock side, your portfolios are built for growth through prudent, value-conscious ownership of good businesses, which also do well through inflationary times – though we add the caveat that at lower prices, which may come with an inflation surprise, we will happily allocate you more heavily to stocks. We continue to carefully evaluate a right time to balance risk and reward on the real estate side, because good-value real assets can also be excellent investments in a period of rising inflation. And, your gold investments should do well during an initial period where inflation is registering but, as we expect, the Federal Reserve will be accommodating by not raising rates until some time later.

All in, we think it is wise to expect the unexpected, and not to be dogmatic about a specific eventuality that inflation is coming, but to be open to the possibility that this change is ahead – as well as to the dangers it entails and the opportunities it can create.

This is a general assessment of client portfolios and does not reflect the specific circumstance of every client.