Inflation Has Arrived - Here’s What That Could Mean For Markets

March 8, 2017

Inflation Has Arrived – Here’s What That Could Mean For Markets

  • After 7 years of enjoying interest rates close to zero, the party is over.
  • There are several scenarios that can develop, but the long-term outcome is clear.
  • In the short term, higher interest rates should increase demand for the dollar and U.S. assets, so we could see a higher S&P 500 in combination with higher interest rates.

Introduction

For the past year I have been writing about how things are bound to change when inflation finally arrives. Well, inflation has arrived and it’s quickly going higher which means that we’ll have to start talking in nominal and real returns, the FED will be forced to take action no matter the economic environment, and it will have significant repercussions on the economy and markets.

Usually when I’ve written about inflation, it was about something that will happen somewhere in the future. Now that inflation is finally here, I’ll discuss what will happen in the short term.


Figure 1: U.S. inflation rate. Source: Trading Economics.

The FED Will Be Forced To Raise Rates 

In her last speech at the Executives’ Club of Chicago, Janet Yellen announced new rate hikes as the economy will probably moderately expand in the coming years, labor market conditions will strengthen, and inflation will be around 2% in the medium term. Of the above reasons, practically only one reason, inflation, is the trigger for higher interest rates. Economic growth was even stronger a few years ago, but the FED didn’t immediately raise rates.


Figure 2: U.S. GDP annual growth rate. Source: Trading Economics.

The labor market has also been strong for a while as unemployment has reached natural levels. The unemployment level hasn’t change much in the last year and a half.


Figure 3: Total employment and unemployment rate. Source: FRED.

Therefore, the only reason why the FED will be raising rates is inflation. For seven years, inflation wasn’t an issue and it would have been political suicide to tighten monetary policy while it wasn’t necessary and things were good. With inflation breaking the 2% level, the days of easy monetary policy may be gone. There are several scenarios that could develop and we’ll discuss them in this article.

Will This Time Be Different?

Lately I’ve been hearing the most dangerous words in investing, “this time it’s different,” when listening to the general media discussing rate hikes. That it will be different is what everybody hopes because history shows a pretty scary statistic. In 9 out of 12 times since the 1950s, higher interest rates have lead to a recession.


Figure 4: Federal funds rate, GDP growth and recessions (gray areas). Red arrow, tightening followed by a recession. Green arrow, tightening without a recession. Source: FRED.

The periods where a recession didn’t immediately follow tightening were usually just after a recession. Think 1962, 1983 and 1994. As we’ve already got 8 years of economic growth behind us, history tells us that a recession is imminent in the next few years.

I don’t believe this time will be different because the FED is forced to control inflation and keep it around 2% in order to prevent the economy from overheating. An overheated economy, with credit on steroids, leads to a difficult recession like the one we experienced in 2009. Therefore, a small recession will be good for the economy as it will weed out all the businesses that are alive only thanks to low interest rates. This will create the basis for future, stable, and sustainable economic growth.

Europe, Japan & Emerging Markets Could Make The Dollar Boom For A While

As the FED is now forced to increase interest rates while both Europe and Japan continue with their crazy easing policies, the dollar is getting and will probably get even stronger.


Figure 5: Trade Weighted U.S. Dollar Index: Major Currencies. Source: FRED.

Higher interest rates will only increase global demand for the dollar and U.S. assets which could lead to further increases in asset prices and an ever stronger dollar.

Emerging countries and corporations might have difficulties in repaying dollar denominated debt which could put pressure on them and lead to an outflow of funds. Funds will rush to security, i.e. the U.S. dollar, pushing it higher and pushing asset prices and inflation higher. This won’t be good for the economy in the long term, but is a possible scenario that would keep markets high.

However, such a scenario will be only for a short time as a strong dollar makes the American economy less competitive on a global scale. In the long term, this will lead to lower productivity and lower corporate international revenues and earnings.

Apart from lowering international earnings, higher interest rates will also increase the cost of debt. This will, in time, put pressure not only on corporate earnings, but also on public budgets.


Figure 6: 10-Year Treasury Constant Maturity Rate. Source: FRED.

A higher risk-free rate will eventually lead to higher required returns from riskier assets like stocks and corporate bonds. This will inevitably bring the market down.

Conclusion & Investment Perspective

We’re in for some interesting times. The market is clearly overvalued but can still go higher. However, a significant change in monetary policy is the trigger that could lead us to the first bear market in this decade.

In regards to investments, all of the above doesn’t really matter that much if you buy businesses. If you buy stocks, all of the above is of extreme importance.

Let me elaborate, if you own good businesses that have a competitive advantage inherent only to them, you can be certain that those businesses will perform well in any kind of economic environment. A business should be looked at from a perspective where everything could change.

What happens to a business if inflation increases? What happens if interest rates increase? What happens if the economy slows down? What happens if there is a shock to the sector? And so on. A ‘nothing much’ answer to all of the above questions would mean that such a business is a good all-weather investment.

On the other hand, if a business has high levels of debt, is very elastic to economic performance, or is extremely overvalued, any kind of change in the current economic environment would mean trouble. An asset class that could see difficult times due to higher interest rates are bonds and the general market, the S&P 500. As interest rates go higher, bond values decline, and there is nothing that can be done there.

But something can be done with stocks. The S&P 500’s price to book value is 3.0, meaning that there is no margin of safety and everything is based on earnings. As corporations have intensively used low interest rates to load up on as much debt as they could, higher interest rates would lead to lots of refinancing problems and higher interest costs.


Figure 7: Net debt issuance/reduction for the S&P 500. Source: FACTSET.

The conclusion here is simple. The market is standing on shaky legs. Therefore, be sure to own assets that have a margin of safety, low debt, and strong economics no matter what happens. These aren’t that hard to find with a bit of research and the potential market decline sure makes the research worth it.