While U.S. inflation remains at historic lows, it has ticked up recently, leaving many investors fearing that it’s time to prepare portfolios for rising prices.
Some fears are primal. For investors, particularly those old enough to remember “The Great Inflation” of the 1970s and early 1980s, inflation is one of them. This fear is reinforced by the widespread perception among market watchers that six years of extraordinary monetary stimulus will inevitably lead to inflation.
As I’ve expressed in the past, given the United States’ unresolved fiscal issues, still excessive non-financial debt, and uncertain path toward monetary normalization, fearing inflation isn’t irrational. However, as of today, it may still be premature.
Recent readings have shown that inflation has stabilized, which is a good thing, but signs of an imminent acceleration in inflation are still scant. In other words, it’s probably too early to restructure a portfolio around a big shift in the inflation outlook. Consider these four facts.
Consumer inflation is still historically low. While it’s true that inflation has risen from last year’s lows – the consumer price index (CPI) has doubled over the past 7 months – the rise needs to be placed in context. Both the CPI and producer price index (PPI) have only reverted back to their three-year average.
Other measures of inflation look more benign.Core PPI is at 1.8%, its post-recession average. More importantly, the core personal consumption expenditure (core PCE), the Fed’s preferred measure of inflation, is at 1.5%, still well below the Fed’s target of 2%.
Inflation expectations remain stable. Both the University of Michigan’s 1- and 5-year measures of inflation expectations are at, or below, the middle of their respective 3-year range. Ten-year inflation expectations from the Treasury Inflation-Protected Securities (TIPS) market remain stable at roughly 2.25%.
Wage inflation remains subdued. Much of the recent anxiety about inflation has focused on two areas: housing and the labor market. On the former, there is some evidence of housing inflation. The Owner Equivalent Rent (the Labor Department’s measure of housing inflation) is at 2.6%, the highest level since the summer of 2008. I believe this reflects a rebound in housing and a growing willingness to rent. However, evidence of wage inflation is more difficult to come by. While most measures of wages have accelerated from last year’s lows, they remain subdued. Hourly wages are rising at 2% year-over-year, consistent with the subdued pace we’ve witnessed since the recession ended. A more complete measure of wages – the Employment Cost Index (ECI) – is growing at 1.8% year-over-year, right in the middle of its post-recession range.
Without more tangible evidence of a pickup in wages, I’d avoid restructuring a portfolio around expectations of imminent inflation. That said, over the long term, investors should be concerned about preserving purchasing power. Unfortunately, some of the traditional inflation hedges are expensive, despite the dearth of imminent inflation signs.
For example, TIPS are barely providing a positive real yield, even before taking taxes into account. And as I recently discussed, while gold and silver both have a place in a portfolio, the potential for rising real-rates calls into question whether now is the right time to add to precious metal positions.
Instead, I’d look to equities to provide a long-term hedge against an eventual pickup in inflation. In particular, I continue to like energy stocks. Despite outperforming year-to-date, the energy sector is one of the few segments of the market that still appears inexpensive. Finally, the sector has an additional benefit: In the past, energy stocks have been one of the better performers when inflation is rising.
Sources: BlackRock, Bloomberg, Citi Investment Research
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