Over the past thirty years, inflation in the U.S. has averaged just below 3% per year. For many investors, we fear this extended period of price stability has created a complacency about the impact inflation can have on the returns of different asset classes.
But the events that have unfolded since the credit crisis of 2008 should challenge this attitude. The crisis sowed the seeds for the possibility of rising inflation. Central banks have increasingly engaged in unconventional monetary policy, and debt levels among developed market governments have ballooned. Monetization of government debt through inflation could be a logical result.
Further, we believe asset prices are much more sensitive to inflation outcomes relative to expectations than actual inflation levels – i.e., investors can react strongly when outcomes differ from expectations. Historically, inflation regime shifts have occurred with little warning. And once a growth spark ignites the inflation gasoline left everywhere by central banks (most recently the Fed with QE3), it may be too late to hedge the effects of inflation.
Therefore, now may be the time for investors who are concerned about inflationary risks to focus on increasing their exposure to asset classes that tend to provide a positive beta to changes in inflation.
While stocks and bonds have generally performed poorly during periods of high and rising inflation, a number of other asset classes have performed relatively well – including commodities, foreign currencies, gold and TIPS.
Currently there is little in the way on inflation pressures with core inflation running in line with its average of the last 20 years. While it is hard to say with certainty when inflation will move higher, we can identify some of the potential catalysts.
- A commodity supply shock, such as the closure of the Straits of Hormuz or widespread regional unrest in the Middle East, is one near-term catalyst that could move inflation materially higher. Recall that in the inflationary episode of the 1970s, it was the Arab Oil Embargo in 1973 that caused inflation to double from 5% to 10%.
- Increased demand and decreased level of unemployment. As this happens, the Fed will be faced with making a tradeoff between the two components of their dual mandate, price stability and full employment. It is in making this tradeoff during the coming economic recovery that we see the catalyst for inflation. The Fed may err on the side of seeking greater employment and a stronger recovery, believing that temporarily higher inflation can be reversed.
- Central banks globally have been engaged in a series of unconventional policy measures and competitive currency devaluation.
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