June 2019 Perspective: Economic and Investment Outlook

06.20.2019 - Ronald J. Sanchez, CFA

Inflation: Influencing the Economy and Markets

Despite the most recent market pullback, investors would be hard-pressed to find an asset class that has failed to produce positive returns in 2019. Returns so far this year have been broad-based and undifferentiated—even asset classes that often move in opposite directions have been moving in tandem. 

Performance through the end of May:
Asset classes. The S&P 500 returned over 10.7% and US long-dated Treasuries gained almost 9.5%.
Investment styles. US growth stocks returned 13.7% and value stocks gained 8.5%.
Fixed income. Treasuries returned 4.2% and investment-grade corporate credits gained 7.2%.
Sectors. Consumer Discretionary returned 13% and Utilities gained 11%.
Commodities. Oil returned 16.5% and gold returned 1.9%.

What is notable is that investment styles and market sectors with different characteristics, including those that are generally sensitive to growth and others that are considered safe havens, are in sync. In an uncommon alignment, global equities, global sovereign bonds and commodities have all rallied this year.

Illustrating the depth and breadth of stock market returns, a little over 80% of the companies in the S&P 500 Index have positive performance so far this year.

An Ideal Backdrop for Both Stocks and Bonds
What environment is so favorable for both risky and risk-free assets? When capital markets are moving higher in tandem and all investments within a balanced, diversified portfolio are performing well, it’s usually reflective of an ideal economic and policy backdrop—a combination of moderate growth and low inflation commonly referred to as a “Goldilocks” environment.

The economy has been growing at approximately 2% a year for the last decade, which is roughly equal to the long-term trend growth rate of the economy. This alignment of actual growth with the long-term trend growth rate, and with little deviation, has created an ideal equilibrium that has extended the current economic cycle.

Of course, a broad range of technological, demographic and market factors have also affected inflation. But in simple terms, supply and demand are in balance, keeping inflation subdued.

It was this very dynamic that allowed the Federal Reserve to pivot away from its tightening policy bias in January after markets ran into severe volatility in the fourth quarter. Given the benign level of inflation, the Fed has the luxury of keeping rates steady at a lower rate than might otherwise be required.

The Fed Achieved Half of its Dual Mandate
Fed policy decisions are driven by a dual mandate of full employment and price stability. But with the unemployment rate at 3.6%, the lowest in 50 years, the Fed appears to have largely achieved the former and continues focusing on the latter. However, inflation has fallen short of the Fed’s 2% target for most of the past decade, despite stimulative monetary and fiscal policy measures such as setting the fed funds rate at zero for several years and, more recently, passing tax reform. 

The Fed’s preferred measure of inflation, core Personal Consumption Expenditures (PCE), has remained stubbornly low—at the end of May it was up just 1.6% versus May of 2018. This struggle to generate higher inflation has been puzzling and difficult to explain for both Fed members and economists. And this phenomenon isn’t limited to core consumer prices. It is also evident in wages and other labor costs. 

Low Unemployment, But Modest Wage Growth 

Although economic growth has been moderate, labor markets have been more robust. The unemployment rate in the US has dropped precipitously from the highs seen during the global financial crisis, and payroll growth has averaged 218,000 jobs per month for the past year, a pace which might be considered stellar given that we are entering the tenth year of economic expansion.

If there is a thorn in the side of employment data, it comes in the form of wage growth. Much like the measures of inflation we have discussed, wages have been slow to respond to the perceived tightening slack in the labor force. According to an economic theory known as the Phillips Curve, historically low unemployment should lead to higher wage growth. So, the absence of meaningful wage inflation has led some to believe that this relationship is disconnected. 

The key takeaway is that markets are acutely attuned to inflation data and its influence on asset prices. Today, investors have a strong conviction that inflation will remain well contained, keeping global interest rates artificially low for a very long time. Thus, this outlook on inflation, for all intents and purposes, has effectively become the underpinning for capital market pricing.

Where Has Inflation Been?
Inflation has largely been absent for the better part of this decade. To find a similar environment, we would have to look back to the early 1960s.

From 1960 to 1965, increases in the Consumer Price Index (excluding volatile food and energy prices) averaged only 1.4% per year. It wasn’t until later in the 60s that inflation finally caught up with healthy economic growth.

The next decade and a half would see inflation jump above 10% and US Treasury rates exceed 15%. It was during this period that Fed Chairman Paul Volcker decided growth prospects would have to be sacrificed in order to lift the economy out of stagnation and bring prices back to a more normal level. The primary mechanism by which he accomplished this was the federal funds rate, which he took to a historically high level of over 20%.

By finally getting inflation under control, Volcker launched what would become a three-decade-long bull market in bonds. During the decades that followed Volcker’s tenure as Fed Chairman, inflation gradually trended lower. Where Volcker was tasked with taming inflation, more recent successors have battled to reignite economic growth and dormant inflation.

The Struggle Today: Reviving Inflation

Since the end of the global financial crisis, the core PCE index has averaged growth of just 1.6% per year. Theories for these persistently low levels of inflation range from globalization to technological innovation and demographic shifts. It is clear to us that this phenomenon is not limited to the US. Japan has dealt with its own inflation struggle for the better part of two decades and Europe has been even less successful than the US. In both Japan and Europe, this struggle and low economic growth has led to negative policy rates for quite some time, which has caused distortions in capital markets. Most notably, negative-yielding sovereign bonds have become pervasive, with some $11 trillion worth of government debt still carrying yields below 0%.

Low Rates Have Boosted Profits

The combination of negative and low rates globally has created favorable financial conditions, reducing the cost of borrowing and bolstering corporate profits. This has translated directly into higher valuations, as evidenced by various equity indexes reaching or exceeding all-time highs. For example, the S&P 500 reached an all-time high in May, although ongoing trade tensions have caused a pullback more recently. 

One of the goals of low policy rates, however, is to spur economic activity; and the effectiveness of easy monetary policy in this regard is debatable. The key takeaway is that a decade of struggling to lift inflation has arguably conditioned investors to believe pricing pressures will never manifest themselves. This firmly embedded view has the potential to be a growing risk and bears monitoring.

What Happens if Inflation Reappears?

Market signals suggest inflation will remain below the Fed’s 2% target for the foreseeable future (Chart). In fact, markets are currently pricing in a higher probability of a Fed rate cut than a rate hike. But what happens if inflation actually rises? Implications would be wide-ranging and pervasive across capital markets. 

Borrowing Costs Would Rise
Persistently low rates have created an incentive for corporations to borrow. Access to cheap credit led companies to favor debt rather than equity financing, and the last several years have seen record amounts of share buybacks. Higher levels of financial leverage put these companies at risk, and the benign inflation backdrop could be leading to a false sense of security.

An inflation uptick and corresponding tightening of Fed policy likely would lead to an increase in borrowing costs, which could make refinancing maturing debt difficult. The impact
to the bottom line would clearly be problematic, and equities, particularly those with weaker balance sheets, would likely suffer.

Companies Would Cut Costs
While higher wages might sound great for employees, the firms bearing these costs would inevitably explore ways to soften the blow. Price increases would certainly be an option, but many companies have already achieved historically high profit margins, and further price increases may prove unreachable. The other option would be to cut costs, and there is evidence showing that companies are using technology to reduce their reliance on manual labor.

Bond and Stock Prices Could Fall
Unexpectedly higher inflation would lead to higher nominal rates and force bond prices down. More importantly, however, price increases would lead the Fed to tighten policy, directly affecting the cost and availability of credit.

Equity multiples would also likely take a hit, given that valuations are already above historical averages. Interest rates have a direct impact on equity prices because they function as a discount mechanism for valuations.

Our View: Keep an Eye on Inflation Assumptions
Although there is no shortage of issues and headlines moving the market, we wanted to share our perspective on inflation and its impact on an interconnected economy and capital markets. 

The consensus view regarding inflation is that it is well contained and unlikely to deviate much from the past decade. While we generally share that view, we also understand the risk of becoming complacent. Markets are relying heavily on a “lowflation” view, and in our view, this pervasive investment thesis might be akin to a “crowded trade.”

What should be clear by now is that low inflation has supported and continues to support financial markets. In our view, the continuation of this low inflation environment is the key to maintaining the current Goldilocks environment. But we also recognize the fact that markets are fluid and subject to change and wanted to shine a spotlight on this critical underpinning of inflation expectations and explain why they should not be overlooked.

Kyle Baker, Senior Investment Associate, contributed  to this report.

This communication is intended solely to provide general information. The information and opinions stated are as of June 20, 2019 and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

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