Investment Strategy & Market Update – May 2018
As our team has previously communicated, we believe one of the most important aspects to future economic and stock market performance will be determined by the health of the credit markets. Lending conditions have been favorable for the past five years, allowing corporate borrowers and consumers to refinance high interest rate debt and receive new credit lines. As interest rates rise and credit conditions tighten, friction can be created if the pace of the rate increases exceed the ability of borrowers to absorb the higher interest cost. The below paragraphs detail our current positioning and expectations for rates and inflation heading into the summer.
Grass Roots Inflation
There are many different causes of inflation. The classic description of what causes inflation is “too many dollars chasing too few goods.” When there is excess demand, suppliers have the ability to increase prices – sometimes rapidly should supply be very limited or when demand is excessive.
Given the extremely accommodative interest rate stance from the U.S. Federal Reserve over the past 10 years, many economists expected inflation to become a problem much earlier in the economic cycle. In our opinion there are structural changes across the global economy that will result in atypical inflation behaviors. In other words, history may not be a good future indicator of inflation magnitude or direction.
Inflation can also be caused by a shock to the economic or market system. A good example is the oil embargo of 1973. The termination of oil shipments to the U.S., U.K., Canada and Japan by the members of OPEC led the price of oil to quadruple in less than a year. This created broad-based inflation in many areas of our economy and helped lead America into a recession. This is an extreme example, however it points to the rapid pace inflation can take hold of an otherwise healthy economy.
In today’s environment, consumer inflation has remained stubbornly low resulting in an extended period of loose monetary policy. Inflation has been seen in areas such as health care and housing, but deflation in other areas like clothing and electronics have offset the net effect of the price increases. A trend worth watching, in our opinion, is the recent rise in overall commodity prices coupled with wage gains necessitated by a tight labor market. We call this type of price increase “Grass Roots Inflation” since it is born from bottom-up sources. Labor costs and raw materials represent a large share of final good prices. Companies can choose to pass these higher prices on to their consumers or absorb the costs. To date the increases have been absorbed on balance and not passed on in any meaningful way. Thankfully a robust economy has led to rising revenue and earnings growth, allowing companies some flexibility.
As a result of the recent price trends and the increasing risk of inflation, our team has developed a new tool to help identify early warnings signs of unhealthy inflation. We will communicate any relevant updates to our thinking, in part based on what this new tool is able to uncover.
Inflation, Rates and Bond Risk
As the Federal Reserve extracts liquidity from our economy by increasing short-term rates and reducing the size of their balance sheet, we expect bond prices to feel selling pressure. Interest rates and bond prices have an inverse relationship. As rates rise, the price of existing bonds must adjust downward to account for higher competing coupon payments. The expected price decline for bonds is a risk factor we have been accounting for in our portfolio positioning for some time.
Drawdown in overall bond prices began in earnest in September of 2017, with the overall bond market as reflected by the Barclays Aggregate Bond Index falling close to 3% from peak levels. Our estimation is recent declines could only be a start given the expectation of a 2% upward move in rates over the next 2-3 years. Specialized strategies will be needed in order to limit or eliminate future losses. Our bond positions continue to favor short maturity issues with a preference for floating rate securities which adjust coupon payments as interest rates rise.
If you own individual bond positions or bond mutual funds in outside accounts, we strongly urge you to contact your financial advisor to discuss your options. It is not uncommon for advisors or brokers to invest in long maturity bonds which hold the greatest price risk. Future price volatility and short-term downside may be avoided by allowing our investment team to evaluate your risk. Moving forward in this type of environment demands flexibility, patience and objectivity. We are thankful for the opportunity to serve you, and are honored to have your trust in our team and in our process.
Doug Blanton, CFA®
Chief Investment Officer, Merit Financial Advisors