Inflation Points To A Recession On The Horizon - Here’s What You Need To Know

November 13, 2017

Inflation Points To A Recession On The Horizon – Here’s What You Need To Know

  • Everybody expected high inflation after 2009, but it didn’t happen. There are specific reasons for that.
  • However, higher food and energy prices are pushing inflation higher. The low unemployment rate should help too.
  • Today, I’ll discuss how to best position yourself for an inflationary environment.



Introduction

There is one little bell always ringing in my mind: inflation, inflation, inflation.

From all my analysis, inflation is something that could really shock the financial world. In today’s article, I’ll first show the current inflation levels for the most important economies, and then will dig deeper into what can happen in the next few years and how could that affect your portfolio.

Current Inflation

The current U.S. inflation rate is 2.2% which is in line with the FED’s target rate and should lead to more tightening, especially if inflation goes higher. Inflation in Europe is a bit lower and at 1.4%, and the situation in Japan is the worst of all with an inflation rate of 0.7%.

Figure 1: U.S., EU, and Japanese inflation rate. Source: Wall Street Journal.

The Chinese inflation rate is also close to 2%, and has been moving in line with the above-mentioned countries.

Figure 2: Inflation in China. Source: Trading Economics.

Most developed countries have a low inflation rate, while the rest of the world has much higher inflation rates which means that the biggest currencies keep their strength and don’t allow for inflation.

Figure 3: Global Inflation map. Source: IMF.

Nevertheless, developed countries are now flirting with inflation at 2% which means your returns have to be higher than 2% just to break even, and begs the question, what prevents inflation from going to 4%?

Many forget that the current 10-year Treasury bond and the S&P 500 dividend aren’t enough to cover for inflation. My biggest concern is that the central banks of developed countries won’t be able to keep inflation at 2% for long without significant tightening.

To analyze such a situation, we first have to look at what has kept the inflation rate so low during the last decade of extreme monetary expansion.

In 2016, the composition of the consumer price index in the U.S., which is used to measure inflation, was as follows:

    • 8.6% for food and beverages,
    • 6.7% for energy,
    • 30% for housing, and
    • 30% for other services.

So let’s see what has happened to the above metrics in the last decade.

Food prices have been flat for the last 10 years, and have just recently started t slowly rise again.

Figure 4: Global food price index. Source: FAO.



Another big impact on lower prices in the last few years has been lower energy and commodity prices because those prices are reflected in everything else. However, energy prices seem to be on the rise again.

Figure 5: Energy price index. Source: FRED.

Further, one of the biggest factors of inflation, housing, has also been on a positive trend for a while now.

Figure 6: Housing prices. Source: FRED.

As for the services part of inflation, it has been stable but growing at a very slow pace and below the inflation rate, which means that services are what keep the inflation rate low.

However, the U.S. unemployment rate is below its natural rate, and will have to change direction at some point. The situation in Europe isn’t there yet because the unemployment rate is much higher and closer to 10%.

So from what I see, prices are rising at a much faster rate than what the inflation measure tells us. You might think 2% isn’t much, but when it compounds year after year, you think you’re getting richer but you actually are not. Secondly, with food, energy, and home prices on the rise and services about to go up due to natural economic forces, it’s important to understand how that will impact future inflation and consequently, our portfolios.

Inflation Impact On Portfolio

The first thing to recognize is that the FED has started their tightening process as inflation is around 2% and unemployment is very low. However, the European Central Bank has just promised that it won’t stop its monetary expansion until 2019. This will maintain the artificial environment where most countries borrow at negative interest rates.

The Bank of Japan is also continuing its spending spree, and has no intention to stop. Therefore, given the disparity in the central bank activity, the first thing that should happen is a strengthening of the dollar and conversely, a weakening of the Yen and Euro, which is exactly what has been going on for the last 3 years with various ups and downs.

Figure 7: The dollar index in the last 5 years. Source: FRED.

If the ECB and BOJ continue with their easing policies while the U.S. is the only one tightening, this disparity will likely expand. However, both the EU and Japan might be surprised by inflation because higher inflation—and we’ll see both food and energy prices rising—might disable the continuous easing policies and force higher interest rates.

Given all this, my biggest worry lies not so much with the FED and the U.S. as they have been starting with the tightening, but with Europe and Japan which aren’t tightening at all because higher interest rates would be completely detrimental to their economies.

The New Normal

Something that always worries me is when somebody important speaks the three most dangerous words in economics: “the new normal.”

FED chairwoman, Janet Yellen, just mentioned the words these words in her speech at the International Banking Seminar held in Washington back in October speaking on how we have to accustom ourselves to an environment where low inflation is normal. Someone invoked the words “the new normal” in both 1929 and 2000, and we all know what happened then.

Now lower inflation is unlikely, stable inflation is possible for a while, and higher inflation is definitely a possibility as well. So how should we prepare?

My opinion is that low inflation has been a reflection of low interest rates which enabled a high level of investments which consequently led to high supply. As investments have been low in the commodity and food industry in the last few years due to low prices, the cycle will revert at some point. Economic forces can’t stay out of balance forever.

A factor that is mostly overlooked but extremely important is the demand that will be created in the next 15 years by the extreme growth of the Asian middle class. The expected growth will be without an historic precedent and therefore, won’t be recognized by the market.

Figure 8: Global middle class consumption will account for one third of the global GDP in the next 13 years. Source: Brookings.



Portfolio Implications Of Higher Inflation

First, we should own stocks that can carry higher input costs over to their customers and that won’t be severely impacted by higher interest rates. This means that we should look for companies with long term debt maturities at a fixed interest rate and avoid companies with large medium-term debt burdens at floating interest rates.

Secondly, companies that operate in a sector where there is high competition that won’t allow for higher prices will see their margins squeezed as the cost of primary materials and energy rise. My thoughts wander toward retail, be they online or offline. Looking at commodities might be a good idea, but we have already seen large price jumps in the sector, so be careful not to invest in the hype but try to find the balance price for each commodity.

Be very careful with bonds and any kind of debt investments because the value of them will fall as rates rise. Not only that, but what is the point of owning a 10-year Treasury now when the real return is almost zero?

The next question is whether higher interest rates will lead to a recession. That’s probable, but we first have to see higher inflation and interest rates, then a recession. This is a topic I’ll discuss further in the future.

© 2017 Investiv