Inflation: Where’s the Beef?
American Century Investments
January 19, 2012
With inflation seemingly in check, we reevaluate the near- and longer-term inflation environment, and discuss implications for investor portfolios.
We are often asked in our conversations with clients about our outlook for inflation. It is easy to understand why this topic intrigues so many. Depending on your perspective, inflation can be said to be rising fairly rapidly from low levels seen just a few years ago; or it could be said to be quite restrained, given the calls in recent years for runaway inflation as a result of unprecedented U.S. monetary and fiscal policies and a number of pronounced global economic imbalances. Here we will try to provide some perspective on inflation, giving both our near- and longer-term outlooks, and talk about implications for investors.
Where we are
Inflation has increased notably in recent years. The government’s consumer price index, or CPI, actually declined 0.34% in calendar year 2009, rose 1.64% in 2010, and is up 3.5% for the 12 months ended November, 2011, the latest period for which data are available. If you strip out volatile food and energy prices, you are left with so-called “core CPI,” which is up 2.1% for the trailing 12 months through November. By way of comparison, inflation last increased at a double-digit annual pace in 1981, and CPI has not been as high as 5% since 1990.
While CPI has seen a notable increase in the last few years, it is perhaps not the significant run-up in inflation that some had feared. What’s more, many economists call for inflation to decline going forward. You can tell what the bond market makes of these predictions—the “breakeven rate” between “plain vanilla” and inflation-adjusted Treasury bonds is a little more than 2%, roughly in line with its long-term average. In plain English, this means that the bond market is forecasting inflation of about 2% for the next 10 years. Hardly crisis levels, though that is up from about 1.7% as recently as September.
Where we’re going: Near-term inflation outlook
We expect inflation to remain contained—that is, run at a less-than-5% annual pace—over the near term, say the next 12 months or so. That is because we see a number of countervailing forces keeping inflation at elevated, but not excessively high, levels.
First, weakness in the labor market means a lack of “wage pull” inflation. Indeed, “real” compensation—wages discounted for the rate of inflation—in the third quarter posted the largest decline since the Bureau of Labor Statistics began tracking the data more than 60 years ago.
Second, just as excess labor capacity has a dampening effect on inflation, so too does excess manufacturing capacity. Recent measures of manufacturing activity indicate roughly one-quarter of U.S. industrial capacity is untapped. Said differently, for any increase in demand for U.S. manufactured goods, there is a ready supply of factory output prepared to come on line and offset any potential inflationary pressure.
But we must also recognize that many components of consumer inflation are trending higher. Crucially, costs for shelter, which make up 43% of the CPI when combining both primary and owners-equivalent rents, have been rising. (CPI measures housing costs not in terms of changes in home prices, but by estimating the rental cost of a given property.) According to one real estate investment analyst, the vacancy rate for apartments fell to the lowest level in a decade late last year. Rising costs for shelter help explain the turnaround in CPI in the last few years, and are likely to continue to push up the headline inflation number.
So rather than demand-pull inflation from an expanding economy (caused by rising wages for example), we think we are experiencing modest “cost push” inflation, where rising owner-equivalent rents and commodity prices put upward pressure on CPI, counterbalanced by excess capacity in the labor and manufacturing sectors.
Inflation a longer-term concern
We believe that higher inflation will win out over a longer-term, say three- to five-year, time horizon. We believe this is so largely because of monetary and fiscal policies enacted in response to the 2008 Great Recession, and overhang from the massive debt accumulation and asset bubbles that precipitated the crisis. Specifically, we see three major forces at work that we think are likely to lead to higher inflation ahead:
- Monetary and fiscal policies: The fed funds rate is at record low levels; the Federal Reserve is using a whole host of novel policy tools; and assets on the Fed balance sheet are greater than they have ever been. Meanwhile, deficits in the United States and across the developed world are higher than ever. Burgeoning entitlement spending and rising interest costs argue for massive structural deficits going forward.
- Debt deleveraging on a massive scale likely presents the greatest threat to the financial system going forward, and we think governments will respond to this challenge with currency devaluation and monetization of debt—both of which are inflationary.
- Transformation of emerging market economies: Emerging economies have effectively exported deflation to the developed world for the last 30 years or so. This is beginning to change, however, as emerging markets have seen a meaningful increase in their wages, share of the global economy, and commodity intensity of their economic output.
Let us elaborate on point two. Deleveraging on the face of it connotes consumers devoting resources to paying down debt, rather than consumption. This is not typically thought of as inflationary, and indeed, while austerity measures will be painful in the short run, less debt should benefit economic growth in the long run. But to be clear, debt deleveraging on a massive scale threatens a severe economic slowdown. One need only look at the last several years to see the lengths the Federal Reserve is willing to go to stimulate growth and prevent another recession. We believe that potential policy responses to such a scenario include monetizing debt (increasing the money supply through central bank debt purchases) and currency devaluation (issuing money and then selling that currency). These are inflationary policies over the long term.
Consider the case of Europe, where we continue to see the powerful effects of austerity in Ireland, Greece, Italy, Spain, and now Hungary. What we find is that less government involvement brings less growth and constrains an economy to the point that tax receipts can't keep up with rising commitments and interest payments, particularly in the face of rising interest rates when investors lose confidence. We simply do not believe these conditions will be allowed to persist, and fully expect that we will have “QE3” (a third round of quantitative easing) in the US, in addition to further accommodative monetary policies in Europe and by central banks around the world. This is not Japan being allowed to de-lever alone in the 1990s and 2000s. In that case, deleveraging came at the price of two “lost decades” but was comparatively less painful than what we’re seeing in Europe because the rest of the region was booming, and coordinated fiscal and monetary policies were possible there in a way they simply are not among the European Union’s 27 member countries.
Finally, let us say a word about cost-push inflation and the current state of commodity markets. It is remarkable that we have oil over $100 per barrel given the problems in Europe, slowdown in China, and strong dollar. (Oil and many other commodities are priced in dollars, so the stronger the dollar, the cheaper oil and other commodities.) What happens if we get better-than-expected growth in Asia in 2012; or what if Europe doesn't collapse and instead finds a way to muddle through? Such positive growth surprises would likely put upward pressure on energy and industrial commodity prices. Similarly, some signs of stability or improvement in Europe would likely ease the safe-haven demand we’ve seen supporting the dollar. A falling dollar would likely put strong upward price pressure on commodities. Of course, there are also tensions in the Middle East, and other potential supply pinch points.
To be clear, we are not attempting to paint a picture of looming hyperinflation. Inflation outcomes are impossible to predict. But we do believe that the risk of an inflation surprise and/or sustained high inflation in the next three to five years is greater than at any time in the recent past. Either of these inflation outcomes could be quite destructive to stock and bond holdings. In this environment of heightened uncertainty, we think it is vitally important to hedge investor portfolios against inflation risk with a modest, permanent allocation to inflation-protected assets.
Goldilocks has left the building
To put this into some sort of context, let’s step back and look and the broad sweep of the markets. In a big-picture sense, the market is always faced with three inflation scenarios:
- A “Goldilocks” scenario where both growth and inflation are “just right,” such as characterized the U.S. economy in the 1950s and 1990s;
- Either disinflation (a slowdown in the rate of inflation) or deflation (an outright decline in prices) scenarios, such as we have experienced in broad terms for the last 30 years;
- A scenario where we get persistent, rapid increases in inflation, such as we have not seen since the 1970s.
Investors will be familiar with scenarios one and two—we have experienced these phenomena for extended periods since then-Fed Chairman Paul Volcker “broke the back” of inflation in the early 1980s. Unfortunately, we believe the probability of returning to a Goldilocks economic environment is fairly low in the so-called “new normal” world of low growth, debt constrained consumers and governments, and increased probability of “tail events”—unusual shocks or events at the “tail” of a normal distribution.
Similarly, it is hard to see the disinflationary environment of the last 30 years continuing for an extended period of time for all the reasons cited above. And in any event, investors and financial markets have 30 years of experience dealing with this sort of investment climate.
What we have not seen in any meaningful way since the 1970s, however, are steady, persistent increases in inflation. It is scenario three that we believe investors would do well to consider and to begin to prepare for now. Generally speaking, we find that investors and the financial media tend to view investment issues as "front and center " or "off the table" and basically nonexistent. But everything we know about investing tells us that investors are more likely to be successful using a more systematic, proactive approach than one which is reactive and indiscriminate. The same can be said for an approach to inflation protection.
Get the timing right ahead of time
We believe it is far better to reflect on and prepare for inflation now, when inflation protection is comparatively cheap. As mentioned, the breakeven rate on inflation-protected bonds is about 2%, which is in line with the average since the Treasury began issuing these securities in the late 1990s. Similarly, recent surveys of investor sentiment place inflation expectations at around 3%. Again, that’s generally consistent with the long-term average for inflation. We believe beginning to add inflation protection now, when inflation expectations are fairly modest, is preferable to waiting for significant inflation to materialize and then trying to implement an inflation-protection strategy. Indeed, timing the purchase of inflation-hedging assets is important—investors reap the highest degree of inflation protection by building positions before the market sees the white’s of inflation’s eyes. Or, as a popular investing aphorism goes, it’s better to get the timing right ahead of time.
It also pays to keep in mind that from an investor’s point of view, the big concern is unexpected inflation. Expected inflation is by definition easier to anticipate and deal with. But inflation surprises can dramatically affect the performance of investor portfolios. So, for example, lower-than-expected inflation is likely to be positive for the performance of stocks and nominal bonds, while higher-than-expected inflation readings can detract meaningfully from results. Indeed, while equities tend to outperform inflation in moderate inflationary scenarios, stocks tend to suffer from inflation surprises. It is unexpected inflation that can damage asset values and for which investors ought to prepare.
Precisely because inflation surprises are by definition impossible to predict, trying to time the purchase of inflation-protected assets is unlikely to be successful. Therefore, we believe a permanent allocation to inflation-hedging strategies is a much more sound investment approach. A comparison with life insurance may be instructive: the longer you wait, the more expensive such insurance becomes. Similarly, waiting for evidence of inflation to show up in CPI and other prominent measures likely means that the price of inflation-protected assets will have skyrocketed.
Diversification does not assure a profit nor does it protect against loss of principal.
The opinions expressed are those of Bob Gahagan and Bill Martin and are no guarantee of the future performance of any American Century Investments® portfolio. This information is not intended to serve as investment advice; it is for educational purposes only.
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