Inflation Coming? Not Yet

Stocks' Winning Ways Continue

With another week came another round of gains for equity markets. Last week, the Dow Jones Industrial Average climbed 1.6% to 15,354, the S&P 500 Index rose 2.1% to 1,667 and the Nasdaq Composite advanced 1.8% to 3,498. In fixed income markets, yields continued their slow climb higher (as prices correspondingly slid lower), with the yield on the 10-year Treasury rising slightly from 1.90% to 1.95%.

Higher Inflation is Not on the Horizon

One of the questions being asked by many investors is when will inflation rear its head. With the Federal Reserve keeping interest rates so low for so long, there has long been an expectation among many that inflation will be rising. For the past several years, however, inflation has remained contained and our expectation is that the inflation environment is unlikely to change any time soon. The bottom line is that with the economy still in the midst of a fragile recovery and with long-term headwinds keeping prices down, inflation is unlikely to become a problem for at least another 12 to 18 months.

Last week's data provided some additional evidence on this front. Not only were inflation readings still low, but the data showed that inflation is actually falling. April's consumer price index (CPI) and producer price index (PPI) both showed sharp decelerations in US inflation. The CPI, in fact, is now up a scant 1.1% over the past year. While some of the low levels of inflation can be attributed to falling energy prices, even core inflation (which strips out volatile energy and food prices) is up just 1.7% over the last year. By any measure, US inflation is well below the Fed's stated target of 2%.

So why is this the case? To start, we need to look at the state of the economy. The US economy is still continuing to grow, but it is doing so at a weak pace, and probably one that is slower now than it was in the first quarter. Last week's economic data showed a decline in industrial production, which is consistent with the overall trend we have been seeing for several weeks. Indeed, most economic reports are now coming in below expectations. We are hardly suggesting that the economy is headed back to recession, but there is a reasonable amount of data suggesting economic growth has softened. Such a pattern can help explain why inflation is falling as well.

In addition to weaker growth, some longer-term factors are at work as well. First, consumers remain cautious about borrowing money (attributable at least in part to elevated unemployment and weak wage growth), which has led to a tepid environment of bank lending. This, in turn, translates into a slower rate of growth in the money supply. Second, as we have been discussing for some time, wage growth remains anemic . As long as jobs growth remains slow, wage growth is unlikely to increase and it is hard to envision an inflationary environment without increases in wages. Finally, we would also point out that the trend of increased US energy production through more natural gas and oil drilling has led to lower and more stable energy prices.

Low Inflation Implications: Good for Stocks and High Yield; Bad for Gold

From a financial markets and investment perspective, there are several implications for continued low inflation. Regarding monetary policy, low and falling inflation means that there is little pressure for the Fed to take its foot off the monetary accelerator. In other words, the Fed can err on the side of too much stimulus. As such, the central bank is likely to be very slow to change its accommodative stance, which should be good news for stocks and high yield bonds in the near term.

Low inflation, however, is not good news for gold prices. All else being equal, declining inflation is likely to result in lower prices for gold since investors will be less inclined to seek out inflation hedges.

Finally, we would say that lower inflation confirms our outlook for slowly rising interest rates. We continue to believe that interest rates are on an erratic and slow upward trajectory (as the last few weeks have demonstrated) and we are not expecting to see the type of jump in inflation that could help trigger a dramatic increase in interest rates.

 

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