We all hate inflation when the cost of goods and services rise. Fortunately, for more than a decade, inflation in the United States has remained low, and we have all become accustomed to prices slowly, gently rising over time. Similarly, the stock and bond markets have become accustomed to stable, low inflation, and that has helped propel the current stock market gains. What consumers and markets both hate is a sudden jump in prices or a sudden change in inflation expectations. In recent weeks we have had such an event, as continued good economic news helped ignite fears of inflation, resulting in a sell-off in both the stock and bond markets.
One of the primary causes of inflation is wage growth, and so economists focus on unemployment and the labor market. Somewhat ironically, as the job market continues to improve, concerns grow that companies will need to compete for employees with higher wages. Although this is a great thing for workers, from an economic perspective, higher wages can result in higher prices as those workers spend their earnings.
Similarly, as the economy continues to improve, price pressure grows on all kinds of commodities, from oil and steel to cotton and coffee. If the global economy grows too quickly, new sources of these resources are not immediately available, and prices can rise quickly.
Currently, inflation is still very low by historical standards but has risen to a 6-year high. While the market outlook for inflation remains very low, and the most likely scenario is that inflation will remain calm, many fear that the Federal Reserve will be too slow to raise rates, allowing inflation to rise to problematic levels. As a result, the market appears to be very sensitive to signs that inflation is rising above expectations.
Stocks and bonds both hate inflation because it eats into the returns that investors expect to receive. If an investor expects to receive a 6% return and inflation is 2% per year, then the investor’s real return (return after the impact of inflation) is 4%. If inflation rises to 3% per year, then the real return will fall to 3%. Of course, stocks are a better hedge against inflation than most bonds since companies have the ability to raise prices for their goods and services, potentially increasing the return to offset at least a portion of the increased costs due to inflation. In contrast, most bonds have a fixed return over their life and inflation clearly reduces the return a bond investor will receive.
As much of the investor community, we continue to monitor inflation closely and seek to position the portfolio to be defensive against inflation spikes. This positioning includes short-term bonds that are less sensitive to inflation changes and inflation-protected securities in some of our funds. For now, inflation appears to be rising and far from out of control. We will continue to cautiously watch for signs that inflation is rising.