U.S. stocks have recovered more than half their losses from the February inflation panic. All clear, right?
Well, not quite.
Inflation worries will come back to haunt you as the year plays out. Here are seven reasons why, and what to do now to get prepared.
Reason No. 1: No one expects inflation to be a problem
In the markets, as in life, bad things always seem to hit you when you least expect it. This is not some kind of weird mysticism. It happens for a reason: complacency. When you get complacent about a problem, you stop worrying about it. So when it hits, it is a surprise. OK, that’s a truism, but it can still serve as the foundation for thoughtful market tactics.
A cornerstone of contrarian investing is to examine what other investors are complacent about, and then assess the odds that it might happen. Investors are understandably complacent about inflation now. For years after the 2008 meltdown, “monetarists” and gold bugs issued scary warnings that quantitative easing would bring terrible inflation.
But the joke was on them. It never happened. So nobody believes them anymore. But we all know the ending to the story of the boy who cried wolf.
“We’ve been warned about inflation from the get go in this recovery,” says Leuthold Group chief investment strategist Jim Paulsen, who cautioned ahead of the February meltdown that inflation would soon menace stocks. “But now it is time to listen, because something big has changed.”
What’s changed? Let’s take a look.
Read: What a Jerome Powell Fed means for investors and the economy
Reason No. 2: Wage growth pressure
There’s now a big labor shortage in the U.S. Small companies — the ones that do the most hiring because they are the core of our economy — regularly complain about how hard it is to find quality workers. They have to pay more to get them. The number of small companies planning to raise pay is at the highest level in decades, according to surveys by the National Federation of Independent Business.
This is no surprise. Unemployment hit 4.1% in January for the first time in 17 years. Four-week average unemployment claims just hit a multi-decade low. So that 2.9% average annual earnings growth number, which freaked everyone out in February, is just the beginning. Sure, this number bounces around a lot. So the next print might not be so bad. But don’t let that fool you. This trend is not going away.
Reason No. 3: Fiscal stimulus
One reason is that big swath of “fiscal stimulus” politicians just layered onto the economy — eager as they are to win mid-term elections. Besides the tax cuts, lawmakers agreed to increase federal spending by $300 billion over two years. They added another $80 billion for disaster relief.
This is “an unbelievable fiscal stimulus package to a full-employment economy,” says Joe Lupton, senior global economist at J.P. Morgan. “This is not exactly an economy screaming for fiscal stimulus.”
Lupton predicts unemployment will fall to around 3% in 2019. If he’s right, companies will be bidding wages up even higher.
On top of all this, for the first time in this recovery, global economies are growing in synch with ours. This means more demand in our economy, especially given what’s in store for the dollar.
Reason No. 4: Weak dollar
As I guessed might happen in this column last July, the dollar continued to fall in the second half of 2017. For the full year, the U.S. Dollar Index DXY, -0.33% dropped 10%. This trend will continue for two reasons.
• A lot of people think the dollar goes up when U.S. interest rates go up. This makes sense, intuitively. Investors chase higher yields, right? But the real trick here is to look at why interest rates are going up. If it’s because of higher inflation, as is the case now, that’s bad for the dollar because inflation erodes its buying power. So people sell it.
• The other reason is global economic strength. This has people selling dollar-based assets to free up money to invest abroad. More downward pressure on the dollar.
These trends will continue. A weak dollar boosts U.S. growth and therefore causes inflation, because it attracts foreign demand for U.S. goods. That’s not the only reason a weak dollar causes inflation. Here’s another one.
Reason No. 5: Rising commodity prices
A weak dollar pushes up commodity prices. Commodities are priced in dollars. When the dollar goes down, commodities look cheaper. This increases demand and prices. Given the weakness of the dollar last year, this is already happening. The S&P GSCI commodity index SPGSCI, +0.02% is up about 25% since last summer. That’s creating inflationary pressure, too. Here’s why.
Reason No. 6: Pipeline inflation
The great investing lesson from Wayne Gretzky is that the key in hockey is knowing where the puck is going, not where it is. It’s the same in investing. You need to anticipate what’s going to happen. You can do this with inflation by looking at producer prices. The picture is not pretty for inflation doubters.
Producer prices are rising at about 3%-4% year over year, notes Paulsen, or much higher than the 2.1% for consumer prices. “This means we have cost push pressure on consumer prices,” he says. Labor costs and the price of money (interest rates) are also going up. This suggests producers have to raise prices.
If they don’t, it’s still bad for stocks, because they’ll take a hit in margins and earnings growth. That’ll be a “surprise” because of the widespread inflation complacency. “Wall Street doesn’t have that in the numbers,” says Paulsen.
Reason No. 7: A wonk factor
Historically, wage inflation heats up whenever nominal GDP (GDP before the effects of price hikes are stripped out) exceeds the unemployment rate, observes Paulsen. That crossover happened in the fourth quarter for the first time this recovery. Nominal GDP hit 4.4% and unemployment hit 4.1%.
Since 1960, whenever this crossover happened wage inflation typically accelerated to above 4% from below 3%. (One exception: the early 1980s.)
How to prepare now for inflation shocks to come
It always takes a while for investors to adjust to big changes in the economy. The 10% pullback in the S&P 500 Index SPX, -1.33% in February was just the first pass. “The stock and bond markets are re-pricing themselves for a very different character in the economy,” says Paulsen.
How to position now? Avoid bonds. Or shorten duration and go with inflation-protected bonds if you must own them. In stocks, tilt toward sectors that do better when yields rise. This means financials, technology, materials, energy and small-caps. Weight toward foreign markets because their recoveries are younger than the U.S. recovery. So there’s more room for growth without inflation. Buy commodities. Short the dollar.
I’ve also been cautioning subscribers of my stock newsletter, Brush Up on Stocks, to avoid owning stocks on margin. That can crush you in a downturn and force you to sell stocks you’d be better off holding through turbulence.
How this forecast might be wrong
Many smart economists, like Ed Yardeni of Yardeni Research, believe four persistent structural forces will continue to put a lid on inflation. They are: technology, Amazon.com AMZN, -1.26% cheap foreign labor and the aging of the population. (Older people earn and spend less.)
Next, productivity growth might come to the rescue. Defined as real economic output divided by the numbers of hours worked, productivity growth has been sluggish for years. That’s too bad, because productivity gains blunt the inflation impact of wage increases.
So far, though, the much-anticipated robots have failed to show up for work. Or they take too many coffee breaks. This could change soon. Under President Donald Trump, business confidence and plans for capital spending have firmed up. If that spending materializes, it could boost productivity and moot wage gains. The problem here, says Paulsen, is that it takes a year or two for capital spending to boost productivity. He expects inflation to be a problem for stocks and bonds this year.
The good news in his outlook? He doesn’t see a recession coming. So any sharp selloff probably won’t be the start of a sustained bear market.
At the time of publication, Michael Brush had no positions in any securities mentioned in this column. Brush is a Manhattan-based financial writer who publishes the stock newsletter, Brush Up on Stocks. Brush has covered business for the New York Times and The Economist group, and he attended Columbia Business School in the Knight-Bagehot program.