If you have been following the markets over the past five years inflation has not really been on your radar. In fact the spectre of inflation has been continually elusive — until now.
The common diatribe has been that the Fed’s interest rate policy and quantitative easing would cause inflation to spike with easy money. Not only has this not materialised its absence has confounded many. We have never really thought low rates and QE were sufficient to cause rampant inflation: money trapped in reserves does not really effect the main street economy, it needs to be associated with a rapid rise in the velocity of money. Lately, however, the tightening labour market and constant advance of the US economy have begun to slowly push inflation concerns to the front of investors’ minds.
Here are a few items to consider in regards to inflation and its effect on the markets:
1. What appears to be low risk may be the greatest risk.
Obviously rising inflation and associated rise in interest rates is a very negative development for bonds. Especially low risk bonds like long duration sovereign government bonds. While government bonds typically carry very little credit risk, there can be significant interest rate risk (duration). For example, the ICE Bank of America Global Government Index yields just 1.25 per cent yet carries a duration of nearly eight years. This means that if interest rates were to move up by 1 per cent the value of the bonds would fall by roughly 8 per cent. Rates have been low for so long due, in part, to non-existent inflation and government monetary policies. It strikes me as risky, however, that these rates are so low given potential risks.
In the US for example, a 1 per cent increase in interest rates could mean a roughly 18 per cent decline in the price of 30-year Treasury bonds. Ironically even investment grade bonds could also feel duration’s pinch (unless offset by credit spread tightening) if the economy continues to improve, and interest rates climb. For example, the duration on the ICE BofAML US Corporate Index (a proxy for the investment grade universe) is the highest it has been over the last ~20 years. To be clear, the losses described above are unrealised (as long as the security continues to be held) and are approximations.
2. The same is worth less. Risk free rates are used in discounting cash flows.
All else being equal, rising rates reduce the value of discounted cash flows used in valuing risky assets like equities. If rates continue to rise to compensate investors for higher inflation, streams of cash flows are valued less. The common argument used by many to excuse high multiples has often been that rates are really low in comparison. This moves in reverse as rates rise and justifiable multiples contract — the same values may be viewed as less.
3. You keep less.
The Phillips Curve posits that there is an inverse relationship between the unemployment rate and the inflation rate, and at a certain unemployment rate there is an inflection point where inflation rises. This rate is called the non-accelerating rate of unemployment and forecasting it is extremely difficult. Essentially, as businesses find it harder and harder to fill job openings they are forced to compete for labour via offering higher wages.
If one still believes the Phillips Curve relationship remains intact, then the tighter the labour market gets, the more likely we are to see an increase in inflation. Wages are likely to finally accelerate for workers.
Given the recent strong job numbers, we may be at an inflection point with the labour market. It would not be surprising to see wages move higher as it becomes problematic finding and filling job openings. The rising cost of labour that is not offset with price hikes would crimp margins and lower corporate profits — the lifeblood of returns.
This explains the sell-off in the stock market on Friday after the stronger than expected US jobs report. The highest monthly wage inflation in nine years raised inflation fears. Why would prices not rise? Globalisation and competition will likely limit the extent for many substitutable products. Why would even modest wage gains matter? Low productivity environments don’t offer much relief so meaningful negative profit margin effects could result.
This assessment brings up some worrying aspects. Mainly the fact that correlations have begun to converge as rates have risen. Essentially interest rate increases have begun to pressure the bond market and the equity market at the same time leaving little place to diversify to reduce risk without shorting the stock market. If a stagflation environment were to develop, traditional financial assets would likely offer lower returns than recent history with reduced ability to diversify. No one, of course, knows the future with any certainty but expectations for investing, at this stage, may need to be re-evaluated if they are set under the assumption of historic averages.
• Nathan Kowalski CPA, CA, CFA, CIM is the Chief Financial Officer of Anchor Investment Management Ltd. and the views expressed are his own. The author can be contacted at firstname.lastname@example.org
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