The Biggest Risk to Markets

Forget a potential trade war, geopolitical unrest or ‘the Trumprisk’. Rising inflation is the single biggest risk to investors now.

Torsten Slok, Deutsche Bank international economist reaffirmed our thinking recently stating in a CNBC interview “I think inflation is the mother of all risks here.”

Traditional measures of inflation in the U.S. have steadily risen in recent months, after anemic price pressure for the near decade since the end of the global financial crisis. This comes at a time when the Federal Reserve is hiking interest rates and the economy is broadly enjoying a recovery, uncertainty surrounding the re-emergence of substantial inflation has once again captured the market’s attention.

Every investor has been waiting for inflation, literally, for the last nine years, since the recession ended in 2009. Everyone predicted an inflation event post the GFC as fiscal and expansionary policies were pursed so very aggressively, markets eventually grabbed hold but inflation stay scarily silent.

You could ask why are we starting to see inflation rise now, even after the fed has started increasing rates. The most likely answer is the strong US dollar, an extended and immense fiscal expansion lasting more than a decade pushing  the  economy toward  overheating, a very tight labor market, and recent (albeit modest) price pressure in the wake of trade war possibilities and the constant tariff talk.

It seems like the emergence of inflation has been well forecast, with a recent survey of fund managers by the Bank of America, resulted in a net 82 percent of respondents expecting the core consumer price index to rise over the next year.

Earlier this month, inflation numbers came in hotter than anticipated, signalling inflation pressures could be mounting. The Labor Department reported its CPI rose 2.7 percent year on year.

Slok said further evidence of rising inflation in the coming months would allow the Fed to hike interest rates perhaps more aggressively than the market is currently pricing in. This has been seen by the 10 year treasury note increasing to around 3.15% the highest it has been since the start of 2011.

“If you begin to see more realization of, well, maybe we will have some overshooting in inflation, that will certainly have implications not only for rates, but also for equities, and ultimately, also for the dollar,” he said, adding overshooting inflation targets doesn’t necessarily mean a breakdown in the equity market — so long as the 2 percent mark is not breached substantially to the upside.

“It depends a lot on what the exact profile for what inflation will be. The worry here really is that if inflation does overshoot to the upside, and the biggest worry is, is the market really prepared for more inflation? Then you could have more risks being injected,” Slok said.


Another Veteran investor Jack Ablin is also backing Deutsche’s call about inflation.  He believes the U.S. is inching closer to an inflationary environment not seen since 1980 due to two chief factors: Federal Reserve policy and the trade war.

“We’re starting to see some of it. For example, wage growth [is] trending towards 3 percent, [higher] oil prices and so forth,” the chief investment officer at Cresset Wealth Advisors.

Even though he views inflation as one of the biggest near-term risks facing investors today, Ablin isn’tpredictingthe 1980s’ cripplingrate near 15 percent. Right now, the Federal Reserve has a 2 percent target for inflation for 2018.

“I’m not worried about runaway inflation,” he said. “We kind of cured that in the late ‘70s and early ‘80s. However, in order to prevent runaway inflation, we need an aggressive interest rate policy.”

According to Ablin, it could prompt the Fed to overshoot — eventually lifting interest rates above fair value in order to keep inflation benign. Pair that with the U.S. looking to bring production back home, and Ablin predicts it’s a recipe for an inflation comeback. It’s a trend that’s been absent from the economy for almost four decades.

“This  trend  towards  mercantilism,  in other words   we   want   to  do  all  of  our business domestically and try to keep trade to a minimum, has the potential to  reverse  that pendulum that swung in favor of globalization, in favor of higher productivity, in favor of lower prices and start to shift that the other way,” he said. “The bond market is beginning to get a little concerned about it. Stocks are not there yet.”

He warns that ultimately higher inflation would undermine both stocks and bonds simultaneously, suggesting it’s not  too  early for investors to reduce risk by turning defensive. Ablin doesn’t have a hard timeline, but he sees the potential for inflation to hit stocks hard within the next couple of years.

He likes industries with pricing power such as health care, materials and energy. He also would look to make a move on one of the most interest rate-sensitive groups. “Short REITs,” Ablin said.

Hours before Powell spoke, Inc. announced plans to raise its minimum U.S. hourly wage to $15 effective Nov. 1, applying to more than 350,000 full-time and seasonal workers in the country. That followed moves by other large retailers, including Target Corp. and Costco Wholesale Corp., to boost pay. With interest rates increasing, any investment that lives of a fuel of cheap debt, like infrastructure or property trusts should be starting to worry.  Continue reading “The Biggest Risk to Markets”