The Great Game of Anticipation
The legendary hockey player Wayne Gretzky once stated, “I skate to where the puck is going to be, not where it has been.” We at The Trust Company want to be proactive like Gretzky when it comes to inflation by anticipating the rise in order to help protect and grow our clients’ accounts. To do this, we have interviewed several inflation protection fund managers who can be employed quickly when we think the signs of rising inflation have become apparent. In times of rising inflation, these funds perform well because they invest in assets that are the most sensitive to that market condition. While the time is not yet right to use them, these inflation strategies remain on our bench until it’s time to check them into the game.
By definition, inflation is a sustained increase in the general level of prices for goods and services. It can arise as a natural part of the business cycle or from a systemic shock, such as the 1973 OPEC oil embargo. A key barometer of inflation is the Consumer Price Index (CPI), which measures changes in the prices of consumer goods and services. Chart 1 shows the eight components of CPI weighted by their significance to the average consumer. The Bureau of Labor and Statistics announced on March 18, 2014 a year-over-year CPI of 1.57%. This inflation level is a comparatively low number to the long-term average of 3.83%.
Why is Inflation Low?
Historically, wages have been a significant contributor to inflation. High unemployment resulting from the Great Recession has prevented wage pressures from increasing inflation.. Additionally, increased productivity resulting from technology and offshoring have recently contributed to low wage pressure.
Another factor that drives inflation is the velocity of money – the speed at which money moves through the economy. The more times a dollar is used in business transactions the greater its velocity, which pushes inflation higher. Most economists agree that money is moving at its slowest pace since the 1950s (see Chart 2). As long as money is moving slowly the threat of significant inflation is pretty slim; however, there are recent signs of velocity picking up its pace.
Inflation Isn’t All Bad
Roman philosopher Cicero advised, “Never go to excess, but let moderation be your guide.” Moderate inflation is a sign of a healthy, growing economy and stock returns prove it. History shows that when inflation rose moderately (CPI <4.5%), both domestic stocks (S&P 500) and developed international stocks (MSCI EAFE) performed above their long-term historical returns. When inflation rose significantly (CPI >4.5%), negative returns resulted for both US and developed international stocks.
While we do not currently anticipate an immediate threat, we are proactively structuring our resources to employ inflation protection strategies should they become appropriate. Commodity strategies and emerging market stocks tend to perform well in times of high inflation. We also recognize that some companies have the ability to pass on inflation to their customers through price increases but debt-laden companies tend to struggle in times of high inflation. We are closely monitoring inflation and are particularly watchful for signs of high inflation which can negatively impact investors so that we can protect client accounts and take advantage of opportunities.
For the period ending March 31, 2014, quarter-to-date returns for the S&P 500, MCSI EAFE (international stocks), MSCI ACWI (global stocks), and Barclays U.S. Aggregate Bond indexes were 1.81%, 0.66%, 1.08%, and 1.84% respectively.