A weekly analysis of timely economic strategy issues from Wells Fargo Investment Institute.
All Eyes on Inflation–Why We Expect an Uptick
- Headline consumer price inflation measures in the U.S. and international developed markets recently have softened as energy prices have remained subdued.
- We believe that the recent bout of inflation weakness is likely to be transitory and expect inflation to rise modestly in the second half of the year.
What it may mean for investors
- Rising domestic and international inflation likely will put pressure on yields and prices of U.S. long-term and international developed-market bond issues, but we expect that it will have limited effect on equities.
In the U.S. and developed markets abroad, a number of measures are pointing to weaker inflation levels. We believe that weak energy prices have contributed to the recently low levels of headline inflation. Although we acknowledge that energy prices likely will remain low and range-bound for the next few years, we expect their impact on headline inflation to be transitory. As such, we expect an uptick in headline inflation in the second half of 2017. Should the inflationary environment develop as we anticipate, we would expect gradually-rising inflation to be priced into longer-dated U.S. and international developed-market bonds, potentially pushing yields up and prices down. We also believe that equity prices in the U.S. and developed markets abroad may look through rising prices unless wage inflation moves higher. At that point, we could see price consolidation.
Energy Headwinds to Inflation Are Likely to be Transient
We believe that the recent headline-inflation weakness in the U.S. and developed markets abroad is likely to be transitory. One reason for this conclusion is that— while the decline in energy prices has weighed on near-term headline inflation expectations— energy’s medium-term correlation to other measures of the consumer-price-inflation (CPI) basket appears to be weak. A similar relationship is evident in Europe and Japan, where sudden increases or decreases in energy prices can affect headline inflation but generally have a narrower influence on other near-term inflation measures.
Furthermore, as Chart 1 illustrates, although energy inflation has declined recently, other major segments of CPI remain stable. In fact, housing, the largest component of the CPI basket, has been trending higher. We believe that energy prices would need to remain weak over a multi-year time period to have a lasting effect on consumer prices as a whole.
Modest Inflation and Growth: Investment Implications
If, as we suspect, inflation strengthens through year-end, we would expect central banks to tighten monetary conditions further as the Federal Reserve (Fed) continues to normalize monetary policy and the European Central Bank (ECB) actively discusses its own path toward normalization. For instance, the Fed has laid out a plan to shrink its balance sheet in the coming quarters, while markets have recently begun pricing in the prospect of the ECB tapering its asset-purchase program as soon as early 2018.
From a bond-market perspective, tapering of Fed and ECB asset-purchase programs, coupled with somewhat higher inflation expectations, could lead to steepening of sovereign-debt yield curves in the U.S. and Europe. With this development, long-term yields should rise somewhat faster than short-term yields as investors reconsider holding (inflation-sensitive) long-term bonds. However, if monetary authorities counter inflation with higher rates, short-term rates could rise, causing the yield curve to flatten for developed-market bonds. In either case, gradually-rising yields could lead to heightened levels of bond-market volatility. As a result, we are maintaining our underweight tactical recommendation to the international developed-market bond class. In the U.S. bond market, we favor the intermediate portion of the yield curve due to its lower interest-rate risk relative to longer-term bonds and its higher yields compared to shorter-term bonds. In addition, at current valuations, Treasury Inflation Protected Securities (TIPS) can offer a hedge against unexpected inflation, and we hold a favorable view of this debt sector.
We expect modestly-rising inflation to have a limited impact on U.S. and developed-market equities as the transitory effects of weak energy prices diminish. However, one inflation-related threat to equities could come from higher wages, which may compress corporate margins. Uncertainty about the pace of future wage gains may generate some consolidation and a pullback in U.S. equity prices as the end of this year approaches. Higher wages and resulting margin compression do not appear to be concerns for international developed markets at this time.
As we move into 2018, we expect global economic growth to continue strengthening and inflation to remain below historically-average levels. Global equity prices (with the exception of U.S. small-capitalization stocks) should trend higher next year. We favor cyclical sectors in general and the Financials sector more specifically. Financials may benefit in a rising-rate environment as financial-company margins are likely to rise from a larger net-interest-rate spread (the difference between borrowing and lending rates). We see continued earnings improvement in the international equity markets and compelling valuations in both emerging and developed markets. For investors looking to put new equity dollars to work in an investment portfolio, we recommend developed markets first (based on a favorable economic and earnings environment), followed by emerging markets, and finally, the U.S., where we favor large caps over mid and small caps.
Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. Real estate has special risks including the possible illiquidity of underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions. Treasury Inflation-Protected Securities (TIPS) are subject to interest rate risk, especially when real interest rates rise. This may cause the underlying value of the bond to fluctuate more than other fixed income securities. TIPS have special tax consequences, generating phantom income on the “inflation compensation” component of the principal. A holder of TIPS may be required to report this income annually although no income related to “inflation compensation” is received until maturity.
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