Inflation: A Tale of Two Worlds

The world is facing an inflationary dichotomy. Advanced economies have excess production capacity and little pricing power, leading to an extended period of low inflation. At the same time, emerging markets, sensitive to volatile commodity prices, are experiencing higher inflation. The division is startling.

Northern Trust’s economic team and others expect inflation in the United States to remain low for the next five years or so, running well below the 4.0% trigger for concern. In overheated economies such as China and Brazil, with inflation rates hovering above 5.0%, government efforts are under way to tame inflation. The Eurozone hovers somewhere in between, with March 2011 inflation pegged at 2.7%, but worries remain that higher commodity and fuel prices will filter down into higher wage costs, which could extend this period of higher inflation.

Rising food and commodities prices also have raised concerns that inflation could become a hot button issue in emerging markets, which in turn could affect advanced economies.

Assessing the Inflation Outlook

When deciding how to position their portfolios, institutional investors need to consider two inflation scenarios: mild and wild.

“If inflation remains mild, then stocks do well. That’s because stocks have the benefit of pricing power and investors are not worried about the Fed raising rates,” says Jim McDonald, chief investment strategist at Northern Trust, Chicago. “The wild scenario is where it becomes more treacherous, and the bond market reacts negatively to higher inflation. Then you want exposure to real assets, such as commodities, to protect against this inflation.”

With the United States currently knee-deep in a sluggish recovery, inflation is not expected to be an issue for several years. “We are not expecting an inflation explosion in the United States,” explains McDonald. “We expect to see 2% to 3%, not 5% to 6%, for the next five years.”

Paul Kasriel, chief economist at Northern Trust, Chicago, finds monitoring yields on five-year U.S. Treasury Notes to be a good way to gauge investors’ inflation expectations. The spread between regular five-year U.S. Treasuries and Treasury Inflation-Protected Securities (TIPS) – considered the break-even inflation rate – currently stands at 2.30%. This means the market is anticipating the consumer price index to increase on average by 2.30% per year during the next five years.

“This forecast is derived from investors who are putting their own money on the line,” Kasriel explains. “It shows that the market is not terribly concerned about inflation.” He adds that no financial market is more sensitive to inflation concerns than the U.S. Treasuries market.

The Impact of Food and Energy Costs

Rising food and energy prices also present two distinct inflation scenarios. Food and energy price increases are only part of the U.S. inflation index and do not by themselves signal inflation. Because consumers have little spending power and unemployment remains high, other less volatile components of the consumer price index are likely to stay stable or even slide, reining in overall inflation rates. For example, last year video and audio prices fell by 2.6% and new car costs were only up by 0.1%.

The flipside, however, is that food prices are much more important to developing countries and these prices represent an increasing percentage of their gross domestic product, Kasriel says. “That’s why it is tough on them and arguably why protests started in Egypt,” he notes.

Higher energy prices also loom as inflationary pressures, and prices likely will rise further as revolutionary forces in the Middle East spread to other oil-producing countries. “The three Cs: corn, copper and crude, are increasing in price primarily because of strong demand from emerging market economies that are experiencing rapid overall growth,” Kasriel explains.

McDonald thinks, however, that the food price issue will not linger, and is less a function of demand than of limited supply. “Food inflation is significantly affected by weather as opposed to diets in emerging markets. We think this is temporary and will not continue to climb at this pace.”

Monetary policy is another key consideration as inflation may be controlled by a government’s quick intervention. “If Milton Friedman taught us anything it is that inflation is ever and always a monetary phenomenon,” Kasriel says. “Emerging markets can prevent inflation by raising interest rates or letting their currency rates appreciate.”

Kasriel adds that it appears the U.S. Federal Reserve’s quantitative easing program is working. “People got very exercised over quantitative easing, but it is just one part of the money supply puzzle. I am reasonably sure that Milton Friedman would be endorsing the policy of quantitative easing if he were alive today. Money supply growth was too weak.”

Portfolio Positioning

Despite fairly definitive signs that U.S. inflation will remain low and controlled, markets are fickle. If bubbling emerging markets do not take control of their inflation, problems could spill over to the United States and other developed economies.

“We have reduced our recommended exposure to emerging market equities, as those countries likely will have to raise interest rates to deal with inflationary pressures,” McDonald says. “The United States is much more flexible and thus we favor U.S. equities over emerging markets.”

But if protection against U.S. inflation remains a concern, McDonald says investors could consider investing in real assets or TIPS. “TIPS are an excellent way to hedge against inflation and take advantage of the high credit rating of the U.S. government,” McDonald concludes.

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