AOTW 2016 0826

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Forget Fed rate calls — be ready for the return of inflation
Stephen Foley
This is another of those weeks when markets hang on every word from Janet Yellen, the Federal Reserve chair, who is speaking in Jackson Hole on Friday. Such is the over-analysis of Fedspeak, they hang on every comma and colon too.

But if all investors are listening for from the annual central bankers’ symposium is clues as to whether the Fed raises rates in September, December or 2017, they may miss more important information for the coming year.

A central question is whether the developed world, and the US in particular, is finally about to see an uptick in inflation, which has been subdued for so long since the financial crisis. Getting the right answer to that question could be key to investing success. Smart money investors in the US are already drawing up strategies for a higher-inflation world, and it never hurts to have a few trading ideas in the hopper ready to go.

Ms Yellen’s colleague John Williams, president of the San Francisco Fed, has thrown the idea of raising central banks’ inflation target into the mix of suggestions for making monetary policy more flexible. Further remedies for sluggish economic growth will also be on policymakers’ minds.

Investors listening in on these wonkish discussions may decide that central bankers have some new ideas for rekindling inflation. But there are other reasons to think consumer prices might revive. Average hourly earnings in the US grew at an annual rate of 2.6 per cent last month, and the fact that job growth has outpaced labour force growth suggests upward pressure to come.

Meanwhile politicians around the world seem more willing to use fiscal policy after years of austerity, notably in the UK and Japan but also in the US, where both presidential candidates are talking infrastructure spending.

For years inflation has been the dog that did not bark, and no one is expecting a return to the 1970s. But it may be time to examine potential investment strategies for a no-longer-rock-bottom-inflation world.

This is harder than it sounds. After years of quantitative easing, real assets are trading at elevated prices. Gold, that most traditional inflation hedge, may be too volatile for many investors in the age of exchange traded funds.

However, three broad strategies suggest themselves, one in the bond market and two in equities.

First, favour Treasury inflation-protected securities over other government bonds. Last week the breakeven rate on 10-year Tips — the rate inflation has to average over 10 years for an investor to beat the return from an unprotected Treasury — was less than 1.5 per cent. The market does not expect the Fed even to meet its inflation target of 2 per cent, let alone to exceed or raise it.

Second, favour small-cap equities over large-caps. Jim Paulsen, chief investment strategist at Wells Fargo Asset Management, has pointed out the tight relationship between small-cap outperformance and periods of higher inflation, although the supposed reasons are speculative.

“Large companies usually operate with wider profit margins,” he suggests. “They tend to be more established and therefore often have ‘fluff’, whereas small companies typically run much leaner and meaner.

“Essentially small companies with tight profit margins have greater ‘operating leverage’ compared to larger companies. Thus when inflation accelerates and selling prices can be raised, a larger portion of the enhanced selling price falls to the bottom line of narrow-margin small-cap companies.”

A third potential strategy, also in the equity market, is to bet against the “bond proxies” whose valuations have soared in recent years, such as utilities, and favour those that benefit from higher interest rates, such as financials.

With higher inflation — and rising inflation expectations — likely to push up long-term bond yields, conservative investors who have moved uncomfortably into the equity market in search of yield will be able to move back into fixed income. Meanwhile banks will find themselves better able to make a decent net interest margin, borrowing cheap short-term money and lending it to customers at higher long-term rates.

If the US economy is moving into a period of benign inflation, after years of disinflation and periodic growth scares, that will be a profound shift with implications across the investment landscape. Being ready is more important than gaming out what any phrase of any Fed speech might mean for the year-end fed funds rate.
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