Are Inflationary Pressures in the United States Building?

Answers to our clients’ questions about market action and the market environment in a few paragraphs every two weeks.

Yes. Inflationary pressures in the United States appear to be building, as positively trending wages, expansionary fiscal policies, and protectionist trade barriers feed into a humming economy. Although we expect these pressures signal an increased risk of an inflation scare, we believe the most likely outcome in 2018 is for inflation to grind only modestly higher.

Inflation fears spiked last month, following a government data release indicating the average hourly earnings of all private sector employees grew at its fastest annual rate this cycle. The concern led market-implied inflation expectations (as measured by the ten-year breakeven inflation rate) to widen to a three-year high of 2.14% and contributed to heightened levels of market volatility. Fears have receded, but wage pressures remain present—survey data released last Thursday indicated the percentage of small businesses planning to increase compensation was near a multi-decade high.

Expansionary fiscal policies should support wage gains as well as put upward pressure on broader price levels. With already strong cash flows, business coffers are set to further expand with the drop in the statutory corporate income tax rate from 35% to 21%. This, along with the immediate expensing provision for investment and other enacted changes, has fueled business confidence and earnings expectations. Together with the economy exhibiting some telltale late-cycle signs, we think inflation could be near an inflection point.

Protectionist trade barriers may impact these dynamics. Last week, the Trump administration moved forward with plans to impose new tariffs on steel and aluminum imports, rattling relations between the United States and its trading partners. By itself, the decision’s impact on inflation is likely to be negligible, but it risks tit-for-tat reactions that could escalate to a trade war. Although we do not know how this will play out, new barriers to trade are likely to put upward pressure on prices and may roil markets as they price in higher inflation expectations and greater economic uncertainty.

That said, these inflationary pressures come as price levels have been historically subdued. The Federal Reserve’s preferred inflation gauge, the core PCE index, indicates price levels have only increased by 1.5% in the last year. The measure, which strips out volatile food and energy prices, remains short of the Fed’s 2% target. Although today’s CPI report points to a slightly higher rate for its core measure, the price-level story this cycle has been less about inflationary pressures and more about the disinflationary impact of technology, automation, and e-commerce sites such as Amazon.

We expect the various forces at play will help price levels move only modestly higher in 2018. This expectation (which is broadly consistent with the market’s opinion) should continue to be supportive of risk assets, as our research suggests markets are less sensitive to the level of inflation and more sensitive to whether inflation changes unexpectedly. In looking at data across the last four decades, we find that US equities have, on average, returned roughly 300 basis points (bps) more in real terms during periods when the level of unexpected inflation or deflation is low, relative to those periods when it is high.

Although the risk that inflation overshoots expectations this year has increased, its likelihood still remains low. Moreover, if history is the judge, we doubt an overshoot would be particularly large—periods of unexpected inflation tend to amount to less than 100 bps. But consider that just a couple of years ago, risks for inflation overshooting expectations seemed almost implausible, as energy commodity prices sank and investors learned about negative-yielding debt. Cut to today, with cyclically strong wage growth, expansionary fiscal policies, and new protectionist trade barriers, we believe investors would be wise to ensure their portfolios are properly diversified.

Kevin Rosenbaum is Deputy Head, Capital Markets Research at Cambridge Associates

Originally published on March 13, 2018