Is inflation bubbling below the surface?
Seeking to identify near-term risks to the US economy and its financial markets, the Janus Asset Allocation Team noticed that the prospect of an acceleration in inflation has been largely absent from the conversation. In our view, this omission is a mistake. We first noted this risk late last year when we cautioned that unit labor costs appeared set to rise. When we published our Janus Market GPSTM in January, we believed the low unemployment rate inferred a tight labor market for the most productive workers and that any future employment gains would likely come at the expense of diminished productivity.
The view was outside consensus forecasts at the time, but now our proprietary model indicates that financial markets reflect the possibility that a long-delayed upward move in prices may be on the horizon. Our option-based model was designed to provide insight into which asset classes and sectors are best positioned to weather such an environment. Given the extended period of stubbornly low price pressures, we believe investors may want to consider preparing for a long-delayed uptick in inflation. Of primary importance is identifying the specific sources of rising prices and how they will reverberate through the real economy and financial markets.
A Transfer from Monetary to Fiscal Stimulus?
In addition to tight labor markets for skilled workers and an expected resultant uptick in wages, upward price pressure may also stem from the expansion in the money supply in the years since the Federal Reserve (Fed) launched its quantitative easing program. The surge in the money supply has – up to now – failed to cycle through the economy, as evidenced by historically low velocity. We believe that this will change, and that the catalyst will be the wave of fiscal stimulus.
Both major party nominees for the US presidency have hinted at their preference to increase public spending, especially on infrastructure. We believe that whoever wins November’s election, he or she will inherit the traditional “honeymoon” period in early 2017 – lasting perhaps as long as six months – when Congress will defer to the administration’s agenda. The Fed has long championed fiscal stimulus as a necessary complement to its accommodative monetary policy. At this stage of the economic recovery, we believe a hand-off from monetary stimulus to fiscal stimulus would support growth and enable the Fed to gradually normalize monetary policy through incremental rate hikes.
We consider fiscal stimulus an effective tool to reflate the economy, especially given our view that the most recent iterations of expansive monetary policy resulted in diminishing returns. Rather than reigniting the “animal spirits” of the US economy, low rates largely created an environment conducive to financial engineering. Companies, to a degree, used favorable borrowing conditions to re-lever balance sheets to boost earnings rather than invest in new projects. Fiscal stimulus, in our view, would have a more direct impact on the real economy, putting people to work on infrastructure projects and increasing government expenditures across a range of channels. We feel the end result would be an increase in demand-pull inflation, especially as longer-duration initiatives would entice both consumers and companies to spend their income gains rather than save them. This demand-pull driver combined with the cost-push inflation driven by tighter labor supply and the recent reset of commodities prices to a higher range creates an environment where inflation is a very real possibility, which ironically is largely ignored by the market.
Monetary policy still has a role
We believe the prospect for rising inflation reflected in our models is largely premised on a political climate that may be more conducive for fiscal stimulus. In order to keep aggregate price gains on the 2% track, the hand off between monetary stimulus and fiscal stimulus must be seamless. Otherwise, one downside risk we foresee is the threat of stagflation, inflation driven by
cost-push pressures with no increases on the demand side. Outweighing these risks is the opportunity for the Fed to raise rates to a sufficient level so it once again has monetary capacity to combat any future economic downturn. The global economy would, in our opinion, reap benefits as well, especially emerging markets. These countries are major sources of the products that would see an increase in demand from a healthy US consumer. And amid all these positive potential right tails, the power of security selection will return, unlocked by the normalization of rates. Economics and fundamentals will ultimately win.