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The 2 Biggest Risks with High Inflation
There's too much focus on the current rate of inflation and not enough on its potential effects. Chief Investment Strategist Jim McDonald analyzes the real risks of inflation to investors.
Inflation remains top of mind for investors, but we don't think the analysis goes deep enough. There is too much focus just on the current rate of inflation and not enough on its potential effects. We think the two biggest risks of higher inflation are pressures on corporate profitability and the potential for higher interest rates, and neither are flashing warning signs so far. Let's take a closer look.
Objectively, the current rate of US consumer price inflation at 6.2% is worryingly high. However, corporate profits have surged as pricing power and operating leverage have allowed companies to more than recoup higher costs. Additionally, the 10-year Treasury yield recently peaked at 1.7% and has dropped to 1.5%.
So what are the trends that we are monitoring that could upend this positive picture? To monitor the corporate profit outlook, we're paying close attention to pricing power and companies' ability to offset higher wage and goods costs. While the current earnings season has highlighted the impact of supply chain disruptions on both revenue and costs, larger companies are generally in better position to manage through these issues.
We expect the eventual moderation of cost pressures to lead to a return of a more competitive pricing environment to achieve market share gains.
Our second trip focuses on the Fed and its reaction function. Should the Fed pivot and start raising interest rates sooner than expected? We think that would not be well received by risk markets and would likely result in a rally in long-dated treasuries. These two scenarios encompass our first risk case, inflation disruption, which focuses on the potential negative consequences of sustained higher inflation.
We made no changes to our global policy model this month and remain overweight risk assets, including developed market stocks, high yield, and natural resources. Supply disruptions and labor shortages have slowed overall growth but should start to ease as workers re-enter the job market and the pandemic recedes. Our China growth disruption risk case highlights the uncertainty about the impact of government policy on the Chinese growth outlook, which supports our favoring of developed market equities.
The Fed did announce the start of tapering bond purchases of $15 billion a month, but we know that this will coincide with a nearly identical reduction in issuance by the Treasury, which should reduce the pressure on rates. This well telegraphed tapering of bond purchases and eventual limited hikes and interest rates doesn't threaten our position of being overweight risk assets and underweight bonds.