Who's Afraid of Inflation?

Model portfolios are no longer one size fits all. In fact, 85% of investors want financial advisors to deliver models customized to their individual goals, investment preferences, and tax circumstances. Discover some of the top themes driving the shift in Seizing the Next Model Moment by BlackRock. But what if inflation does begin to bubble up? Well, what the Federal Reserve can do is they can say, We're going to scale back our purchases of Treasuries. I think the yield curve will steepen. And is that going to cause a correction at some stage for the stock market? Yes. I think there's always a vulnerability to a correction.

Welcome to the Barron's Streetwise Podcast. I'm Jack Howe. The voice you just heard is David Kelly. He's the chief global strategist for JPMorgan Asset Management, and he's talking about inflation. Now I know inflation sounds like a snoozy topic. It's much more exciting to talk about whether Tesla stock will hit a skajillion, but there's a key link between the low inflation we've seen in the U.S. over the past decade and rip-roaring gains for stocks. And lately I'm hearing from a number of people who expect U.S. inflation to pick up soon. So what will that mean for stocks? More on that in a moment. And don't worry if you don't know what the yield curve is and what David means when he talks about its steepening. Lace up your hiking boots and stretch your calves. We'll climb that yield curve together and figure it out. Try to stay hydrated. I'll keep an eye out for bears. With me remotely is our audio producer Meta. Hi, Meta.

Hey, Jack.

Meta, can I do an entire episode on inflation without putting anyone to sleep? And quick follow-up question, are you still awake? Don't try to fool me, Meta. I know you're excited about our listener question on the subject.

I am.

Let's hear it.

Hi, Jack and Meta. Rachel from Delaware here. I love your show and have been a loyal fan since day one.

Hello, Rachel from Delaware. Let me just say that so far I think you're making some important points, but please continue.

I am 30 years old and have been taking a greater interest in my stock investment portfolio this year. Outside of that, I currently have a 401(k), Roth IRA, and a savings account to buy a house and my emergency fund. So here's my question. I read that the Fed may allow for higher inflation rates soon. So what does that mean for my portfolio, and should I make any changes to my stock allocations? I won't need my investments until retirement, so I also wonder if I should just ride out the wave. Thank you so much, you guys are the best.

Thank you, Rachel, and congratulations. At 30 years old, you're building long-term wealth in stocks both inside and outside of your retirement accounts. You've wisely set aside an emergency fund, you're saving for a house, And you've asked what I think is a timely question about the link between inflation and investment returns. Now, inflation in this context means a rise in the cost of living. The cost of living, of course, is different for each person. Young families might spend plenty on diapers and daycare, for example. Older families shell out for college. Some seniors have high healthcare costs. So no single measure of inflation is a perfect fit for everyone, but it's important to measure inflation to know whether life is getting easier or more difficult for workers and investors. Let's spend 25 seconds on how we measure inflation. In the US, the main measure of inflation is the Consumer Price Index, or CPI. It's a basket of goods and services, each with different weightings. For example, footwear and non-alcoholic drinks have roughly the same weightings. Now that might sound strange to someone who spends a lot of time chugging orange juice barefoot, but remember, the index is meant to represent a theoretical average person, and most of us are pretty far from average in our own ways. There are many consumer price indexes, but if someone just says CPI and doesn't specify, they're talking about what's called CPI-U. Which measures prices for all urban consumers, just over 80% of the US population. And that's enough on measurement, except Meta, should I give passing mention to an inflation conspiracy theory? Yes.

Is it super juicy?

It's the juiciest. People sometimes have reasonable disagreements over how best to measure inflation. For example, I've heard pros and cons of linking Social Security payments and their yearly cost of living increase to an index that assumes higher healthcare spending by retirees. But once in a while, you might hear a claim that the entire system is rigged, that the Bureau of Labor Statistics, which reports CPI, is playing politics by, for example, purposely underreporting inflation to hide the negative effects of government policies. I used to hear that a lot years ago, so I looked into the matter. At the time, I found that a lot of these claims traced back to a single person publishing a newsletter with what he claimed were the real inflation figures. I took those claims up with government statisticians and a former commissioner of the Bureau of Labor Statistics, and I found no evidence of a fix. Or systematic mismeasurement, only limits in our ability to perfectly measure things. I doubt we've heard the end of conspiratorial claims about government statistics. They've been around for about as long as government statistics. Also, lately I've been hearing lots of conspiratorial talk covering many subjects, so let's remember how to disprove a conspiracy theory. As an illustration, I'll use the 1993 film So I Married an Axe Murderer in which Mike Myers masterfully plays both the main character and his own cranky father, Stuart.

Give your mother a kiss or I'll kick your teeth in.

Stuart claims the Kentucky Fried Chicken icon Colonel Sanders was part of an elite group that controlled the world. His son asks, Dad, how can you hate the Colonel?

Because he puts an addictive chemical in his chicken that makes you crave it fortnightly, smartass.

So how do you disprove Stewart's conspiracy theory? The answer is you don't. There's something called the burden of proof, and it lies with the person making the extraordinary claim. Hey, I like a bucket of KFC, maybe not quite fortnightly, but once in a while. But I don't think it's because of addictive chemicals, and I'm pretty sure Colonel Sanders never controlled the world. Where's my proof? That's for Stewart to provide because he's the one with the extraordinary claim. I'm just a guy saying fried chicken is tasty, and there's nothing extraordinary about that. Back to business. It's time to figure out whether inflation is rising and what that means for stocks. And for that, I reached out to a leader in leading indicators. Hi, Lakshman. I hear you, but it's very faint.

Is that better now?

Yeah, that's much better. That's Lakshman Achuthan, and he's co-founder of the Economic Cycle Research Institute. His work focuses on identifying turning points for economic growth and inflation.

It's kind of the Achilles heel of free market-oriented economies. The thing is, is they have these turning points. They have an ebb and a flow. So very, very fascinating to think about how to monitor the risk of a cycle in growth or a cycle in inflation kind of catching you off guard. And those turning points often do catch people off guard.

To understand inflation turning points, it's important to know that a smidgen of inflation is good, not too much more and not too much less. If prices rise too quickly, life can become unaffordable. If inflation is too low, there's a risk that prices will go into a long decline called deflation. That might sound like a good thing, like the cost of living going on sale, but deflation can make people put off spending. Why buy something today when it might be cheaper tomorrow? And that lost business can turn into lost jobs creating more deflation, and so on. So economists look for an inflation sweet spot, and America's central bank, the Federal Reserve, thinks 2% inflation is the sweet spot. Now, if we run below that figure, like we have for most of the past decade, the Fed tries to boost economic growth and inflation. It has done that by keeping short-term interest rates near zero. To get people to borrow and spend. One side effect of low interest rates is low bond yields, which makes stocks more attractive by comparison and pushes stock prices higher. That has been one of the main drivers of stock gains over the past decade. So if inflation were to jump, the Fed might have to respond by raising rates to cool the economy., and that might cause stock prices to fall. That's exactly what happened in late 2018, and the Fed had to reverse course and bring interest rates back down. So that's why inflation matters so much for stocks. Now, the inflation rate has been all over the place this year. It started the year low, then it went negative during the first few months of the pandemic, then it turned quite positive over summer, and since then it has moderated. But the Consumer Price Index can only tell us what happened in the recent past, not what to expect in the near future. For that, you need what's called a leading indicator. Lakshman has his own leading indicators for growth and inflation that correctly predicted that 2018 turning point. I asked Lakshman what goes into his inflation leading indicator. Is he like a chef with a secret recipe that he can't share?

So it is proprietary. And so in that sense, we are a bit like a chef, but I want to be clear that it's not that we have a secret ingredient. You know, it's not like I have some special truffle oil that I dropped in and that's the unknown thing that makes it taste so good.

Okay. Hold the truffle oil. What else?

What we're looking at are a limited set of drivers of inflation. Could be something around what's going on with homes or commodity prices or bottlenecks in the system. There are some issues around labor. There are things around the cost of money or the movement of money and credit. So all of those things can, under certain circumstances, really push inflation up.

Lakshman says his future inflation measure began rising 5 months ago. He says people have diverted spending away from experiences and toward things. Think of people who haven't been going to restaurants during the pandemic but have spent money to upgrade their kitchens. Lakshman says the outlook is promising for economic growth and that manufacturing and construction in particular are picking up, but he also says inflation could rise faster than expected.

It could get a little sticky for the Fed because until the future inflation gauge turns down, which it hasn't done, it's still going up, inflation is going to keep rising, probably surprising the consensus expectation over a series of months. And that'll test the Fed's resolve.

What does Lakshman mean when he says that faster than expected inflation could test the Fed's resolve? Well, for one thing, The Fed might not be able to keep rates near zero through 2023 like it has suggested. The Fed has already created some wiggle room. It used to say it was targeting 2% inflation. Now it says it's targeting a 2% average. It's a subtle distinction, but if inflation has run below 2% for years, a 2% average means it would be okay if inflation topped 2% for a while. The latest reading is below 1.5%, so we're not there yet, but the economy is rebounding, and it was helped by massive stimulus spending from Congress, and discussions are underway now over a new round of stimulus. So how much inflation would be too much for stock investors' comfort? For that, I spoke with someone else who predicts higher inflation.

I think there is a real risk of inflation starting in the second half of 2021 and going into 2022 and beyond.

That's David Kelly, the chief global strategist at JPMorgan Asset Management, and he describes the economy now as a V-shaped recovery interrupted. In other words, we've had a sharp bounce, but we're not all the way back, and there's plenty of uncertainty.

The problem is you can't fix the economy until you fix the pandemic, and the pandemic is getting worse. So there's going to be a sort of a screeching of the brakes going into the fourth quarter, where I expect growth to be only about 3%. I do think that ultimately when we finally get past this election, I do think you will see more fiscal stimulus, however the election goes. And I do think we'll see a vaccine next year. And once we have a vaccine that has been widely distributed, I think we will get back to behaving in a normal fashion. And when that happens, I think you get a surge of economic growth.

That sounds hopeful, but hang on. Remember when the government ran big deficits during the global financial crisis to do things like rescue the car industry, and try to stop the plunge in house prices. Well, plenty of people were warning that all that spending at the time would result in runaway inflation, and it never happened. I've heard a lot of explanations for why inflation has stayed so low. For example, globalization has greatly expanded the world's workforce, holding down wages and prices. Also, big tech companies like Airbnb and Uber have created new supply for room rentals and rides, holding down prices. And Amazon is discounting retail goods to gain market share. And then there are low birth rates in rich countries, which increases the share of older folks who tend to save rather than spend. So given all that, why does David think we'll get higher inflation now? Well, he adds another explanation for low inflation. Income inequality, or the widening difference between the rich and poor.

The biggest difference between the rich and the poor is how much they save. And what's been going on is that more and more income has fallen into the hands of the richest households in America and indeed around the world. And so roughly speaking, today, half the pre-tax income in America goes to the top 10% of households. Well, they save about 30% of their income. Instead of buying those goods and services, it ends up buying assets. And that's why you've had these roaring asset markets for years while we've been constantly starving demand for goods and services.

So why might inflation start to go up? David says the long rise in income inequality could soon begin to reverse.

It could be that we will turn the corner on this issue of income inequality. It may be that this fiscal policy not only is just putting money into the economy, but it's actually trying to help poor and middle-income households more than the rich.

If that sounds like social policy, I suppose it is. But in David's view, it's also investment analysis. He says there are no hawks left in Washington, only red and blue doves. And what he means is that lawmakers on the right and left seem less concerned than in the past with deficit spending. Past deficit spending flowed disproportionately to the wealthy, who tend to save, says David. But future deficit spending might flow more to less wealthy consumers who are more likely to spend. And that spending, in his view, is what could lead to a rise in inflation. So how much inflation would be bad for stocks? David says if we get above 2.3% on the measure of inflation the Fed watches, it might respond. We're less than a percentage point away from that now. If inflation does rise a lot, David doesn't think an interest rate hike would be the Fed's first response. See, the Fed has more tools than just raising or lowering short-term interest rates. Meta, maybe this is a good time for a break for a sound effect. What do you have for the Fed's tools? Let me see. Maybe something more aggressive than that. Okay. Oh, that's better. Is that a pit crew? Yeah, I think I see a bear sneaking up on that pit crew.

Oh, me too.

So one of those Fed tools is to buy heaps of long-term Treasuries, which pushes up their prices, which mathematically reduces their yields. The Fed's been doing just that. And David thinks the Fed's first response to higher inflation will be to reduce or halt those Treasury purchases. That could cause long-term bond prices to fall and their yields to rise. By the way, if you watch a lot of financial TV, you're bound to hear someone mention the yield curve. Let's look at kind of textbook curves. Let's look at inverted first. Crazy inverted yield curve. Is the yield curve or interest rates truly an economic indicator of any validity anymore? The idea that equities can't rally with the yield curve inverting is not necessarily true. The yield curve is just a graph of available bond yields, starting with short-term ones and moving to longer-term ones. It typically looks like a hill because longer-term bonds usually have higher yields. Lately, however, the yield curve hasn't looked especially curvaceous because the Fed has been holding down yields on just about everything. If you say the yield curve might steepen, you're just saying that long-term bond yields might rise, only it sounds cooler, as I think I've amply demonstrated. I better not explain the inverted yield curve. I don't want to provide too much titillation in one episode, right, Meta? No matter what you call a rise in long-term bond yields, the bottom line is that higher yields could lure investors away from stocks, pulling stock prices lower. But stock investors shouldn't panic. There are many ifs involved here, and even if you get all of them right, there's still the matter of timing. Here's David.

I think there's always a vulnerability to a correction, but you've got to be careful with this because do you know when the market's going to peak? You know when the market's going to trough? I don't think people are good at timing. What I would say is we need to look broadly at markets overall and say, well, given that rates will go up and something's probably going to get hurt at some stage, what's actually cheap in financial markets and what's expensive?

There you have it, Rachel. A lot of market forecasters have predicted inflation over the past decade and been wrong. But there's reason to believe we could see more inflation now, and rising inflation could hurt stock prices. But even if we could say for sure that was going to happen, we wouldn't know when or by how much. Since you have many years left to save, I don't think it makes sense for you to drastically reduce your allocation to stocks. But David thinks it might be a good time to shift from expensive assets toward cheap ones. Which are those? Shares of big, fast-growing companies are expensive, David says. So are treasuries, which people have bought for safety despite low yields. And that includes the kind of treasuries that adjust to keep up with inflation. David thinks it's a good time to shift to value stocks as well as non-US markets.

What's cheap is value stocks in the United States and then international stocks in general, both emerging market stocks and stocks in Japan and Europe. They all look relatively well valued in this environment. So I want to make sure I'm properly diversified into some of the things that have not been part of the sort of the growth stock frenzy here, or this sort of sheltering for cover in Treasury bonds here, both of which I think have pushed those markets to sort of expensive extremes.

Thank you, Rachel, for sending in your question. And everyone, please keep the questions coming. Just tape on your phone. Using the voice memo app and send it to jack.hough, that's H-O-U-G-H, at barons.com. I have an announcement. Meta and I are doing a live taping of an episode of this podcast November 9th at 1 PM Eastern Time. We'll be speaking with Visa CEO Alfred Kelly. You can sign up at events.barons.com/streetwise. Thank you for listening. Metalootsoft is our producer. Subscribe to the podcast on Apple Podcasts, Spotify, or wherever you listen to podcasts. If you listen on Apple, write us a review. If you want to find out about new stories and new podcast episodes, you can follow me on Twitter. That's @jackhoug-h-o-u-g-h. See you next week.

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