I recently got back from an industry conference and my main takeaway was that 2018 could be the year of inflation. What does that mean and how should we position our portfolios?
To start, why do I think inflation will be ticking up this year? Anecdotally, I’ve heard from many employers from this conference that wages are up 20% year-over-year. That is significant! Recall, that wage growth has been one area stuck in low gear since the crisis, even as employment levels have recovered. As wages increase, firms costs increase and also increases consumers’ income to spend more, which helps inflation.
Turning to actual economics, demand-pull inflation occurs when aggregate demand grows fast than supply. When the economy is at near-full levels of employment, as we are now, that leads to increases in price levels. Why do I think demand will exceed supply? For one, consumer confidence averaged ~97 for all of 2017. That is the highest level since 2000, and according to University of Michigan’s economist, Richard Curtin, “only during the long expansions of the 1960’s and 1990’s was confidence significantly higher.” Plus, the stock market is up and setting new records, home prices are up, and while these do not cause inflation, it causes a positive wealth-effect that encourages the consumer to spend more and can buoy economic growth. In other words, these are indirect causes of demand-pull inflation.
I also tend to think cost-push inflation will also occur in 2018. Take oil and its derivatives for example. While not back above peaks, as we sit with it hovering around $60/barrel, that is well above the average levels of 2015 and 2016. Similar to wages, higher costs of other inputs rising leads to higher prices.
There are a few offsets to these inflationary forces, however. The fed is raising interest rates. Higher rates in the US should drive up the value of the dollar, all things being equal. Higher interest rates attract higher foreign investment, which causes the value of the currency to rise, in this case the dollar. This makes US good less competitive on a global scale. On the flip side however, higher inflation in the US relative to other countries will cause depreciation in the USD relative to those with lower inflation. Therefore, the impact of higher interest rates is mitigated by the fact that the US has higher interest rates than some countries, such as Japan or countries in the Eurozone which are combating deflation. The US also has a pretty bad current-account deficit (that is when a country spends more on foreign goods than domestically produced ones). We likely will continue to spend more on foreign trade than we earn, which will decrease the value of the dollar.
In addition, firms in the US will be able to fully expense capex for tax purposes, instead of the depreciation expense for tax deductions. Firms could invest in automation, crowding out labor and keeping wages down. In essence, we shouldn’t underestimate the deflationary impact technology can have. However, I tend to think this will take time.
But if I had to bet, I think inflation will tick up, which will cause interest rates to rise.
So where should I position my portfolio? Let’s start where I do not want to be. If interest rates finally due rise, the one place I do not want to be is low coupon, higher duration bonds and bond proxies (i.e. stocks that are highly correlated to bonds, like utilities and REITs).
I also do not want to be in stocks that have a long tail. For example, some biotech stocks valuations are through the roof based on the expectation in 3-5 years they will come out with a blockbuster drug. As the discount rate increases, these stocks will get crushed considering their earnings are further out. Tesla is another example of this…
On that note, we should consider that the discount rate for all stocks will be increasing. That could hurt the valuations of a lot of names as the S&P grinds higher (e.g. the S&P historically traded at 15x EPS, but now trades at 18x. Could there be a reversion to the mean?).
Where would I invest in these times? I am tilting my portfolio towards commodities. Although they have had a big run in 2017, we are still well below levels seen in 2011 and 2012 for commodities. If inflation ticks up, these have room to run and can serve as a hedge to my equity holdings. Refer to the chart below to see where we sit in the commodities world compared to recent history (chart depicted is the Bloomberg Commodities Index, which is made up of energy, grain, metals, etc.) Full disclosure, I own XLE, the energy ETF, MOO, the agribusiness ETF, and am considering BCX, Blackrock’s resources and commodities closed end fund, which trades at a ~7% discount to NAV and yields 6%.
Second, a tertiary bet on commodities is countries that benefit from rising commodities. I am also adding to my position with exposure to Brazil. Brazil is still coming out of one of the worst recessions it has seen in a long time in addition to a crack down on corruption. As commodities recover, labor improves and consumer confidence builds following the corruption scandals, Brazil could have a multi-year run ahead of it. I purchased both EWZ as well as BRF, which tilts to small cap, consumer stocks in Brazil as a leveraged bet.
Lastly, while I am avoiding REITs since I believe investors who have been starved for yield have driven up valuations, I do like the building products sector. Real estate tends to perform well in period of inflation, supply remains constrained, and we are still below average housing starts since the last recession. Even if interest rates rose 100-200bps, affordability is also at great levels. As such, I think building products is the sector to be in for the US.