Why some fund managers aren't worried about inflation ... yet
The signs are all there. Friday’s U.S. jobs report showed average hourly earnings posting the largest gain since June 2009. More broadly, government spending is increasing, Treasury rates are jumping, the dollar is sinking, the labor market is tightening and U.S. overnight interest rates are still at historically low levels.
In years past, these have all been warning signs of looming inflation, and some analysts are starting to ring the alarm.
Part of the worry analysts and economists have is that resurgent inflation hasn’t been a major concern for years. Valuations of the stock market are not priced for higher inflation and accompanying higher U.S. interest rates.
Jim Paulsen, chief investment strategist at the Leuthold Group in Minneapolis, sees the inflation rate heading to 3% this year. While that’s not extraordinarily high, it’s well above the expectations of the Federal Reserve and of most market participants.
“There is a complacent attitude that’s at risk of being shocked when we do see some inflation,” Paulsen said in a phone interview. He lists a surprise increase in nominal inflation as his “primary risk” for 2018.
An inflation spike could trigger repricing in stocks and bonds
A surprise in the range of 3% inflation could lead to a major sell-off in stocks. Higher U.S. inflation reduces the value of corporations’ profits, making an equity market that is already at high values by historical metrics look even more so. The S&P 500’s current price to earnings ratio is just under 23, a hair below its peak during the financial crisis in 2009.
The Federal Reserve Bank of Atlanta’s GDP Now tracker shows expectations of 5.4% gross domestic product growth in the first quarter this year. Its year-ahead expectations survey shows business leaders see only 2% inflation – a combination that is highly unlikely.
Rising inflation could also spur the Federal Reserve into raising U.S. interest rates faster than expected. The Fed is currently expected to raise rates three times this year, and its predictable, slow pace over the past two years has been a key driver of the stock market and economic growth.
A recent survey of money managers by Bank of America-Merrill Lynch found they viewed an inflation-inspired bond crash as the biggest danger to financial markets.
“If you take away certainty of moves and gradualness and introduce new risk, certainly the equity market has to reprice itself,” said Larry Hatheway, chief economist and head of multi-asset portfolio solutions at asset manager GAM in London via telephone. “If that’s the case, people say we’re probably going to get a recession 2019 and 2020. It doesn’t take a lot. Just a relatively modest change in inflation could cause a broad market repricing.”