PMC Weekly Review - August 26, 2016
A Macro View – Should We (and the Fed) Be More Concerned About Inflation in 2017?
Since the end of 2010, economists, pundits, portfolio managers, and even the average homeowner have tried to forecast (a fancy word for “guess”) when the Fed would raise interest rates. Most of these “will they or won’t they” arguments centered on US GDP growth and unemployment. More recently, non-US economic growth has been considered and discussed, largely due to the Fed’s use of weak global growth justification for not raising rates at the end of the first quarter. Largely missing from the conversation has been any discussion of inflation, which is not surprising, given that central banks in Japan and the Eurozone have been desperately fighting deflationary trends, and plummeting energy prices over the last two years have kept global inflation to a minimum. But signs of kindling inflation in the US have increased this quarter as the housing market strengthens and employment and wages rise. Mixed data on more traditional manufacturing and business sentiment are also keeping a lid on inflation expectations now, which could have several implications for investors’ portfolios in 2017 and beyond.
As noted in depth in this space last week, the US housing market is rebounding, and the home builders’ confidence index and new housing starts are rising as new permit applications stay flat. New data released this week showed even more strength: new home sales in July hit an eight-year high, a rise of more than 30% higher from a year ago. Existing home sales were modestly lower for the month, though June’s sales were the highest in more than eight years. This demand drove up both the median home price and rents over the last year, by 5.3% and 3.8%, respectively, matching their highest level since 2008. Housing costs are both an obvious and significant part of the average household budget. July’s job report also was strong: 255,000 jobs were created during the month. The headline unemployment rate stayed steady at 4.9%, as more people either entered or re-entered the workforce. Importantly, the report also showed that average hourly wages increased at an annualized rate of 2.6%. In addition, the Atlanta Fed’s Wage Growth Tracker shows median wage growth (a slightly different measure of wage growth) exceeding 3.4% on a rolling three-month basis since the beginning of the second quarter of 2016, a level not seen since early 2009. Finally, core CPI (ex food and energy) came in at 2.2% for the 12 months ended July, above the Fed’s stated target.
However, measures of broader economic growth remain mixed thus far in the third quarter. On the positive side, July’s industrial production jumped 0.7% over June, the largest increase since 2014. Manufacturing capacity utilization also rose to 75.9%, an increase of 0.5%, and the US Leading Economic Indicators Index rose 0.4% in July, and 2.1% over the trailing 12 months. Durable goods orders jumped 4.4% in July, and even when the volatile transportation sector was stripped out, the 1.5% gain was the biggest increase this year. But the Empire State Manufacturing Survey unexpectedly fell into negative territory, whereas the Philly Fed Manufacturing Index turned positive, although the new orders and employment components of the Index were significantly lower than last month.
Headline unemployment has been at or below 5.0% for the last 10 months, and core CPI has been above 2.0% for the last nine. The relatively strong housing market and wage growth normally would be a classic foundation for significant and rising inflation. Yet GDP growth remains weak, broader economic growth indicators are mixed, at best, and interest rates, both here and abroad, remain mired in multi-decade lows. The next 12 weeks will take us beyond the Presidential election, two more Fed meetings, and a raft of economic data. The final spark that ignites the inflationary cycle and leads to higher interest rates could come from several factors. These include: commodity and energy prices continuing to rise, as they have done since mid-first quarter; higher confidence in the election outcome (removing uncertainty); increasing anticipation of a Fed rate hike that strengthens the dollar; or even passage of a fiscal stimulus bill by Congress (or other data points). If and when that spark comes, rising interest rates (predicted for each of the last five calendar years) will have a negative impact on fixed income portfolios, as well as many dividend-oriented equity portfolios. Protecting a broader portfolio can be done through shorter maturities or an increased exposure to TIPS, whose breakeven rate is now well below the actual 12-month core CPI reading. Additional options may include: exposure to commodities, which historically have a high correlation to inflation, or floating rate securities, whose income increases in tandem with higher short-term interest rates. How and when to implement these measures are much more difficult questions, and the answers are specific to investors, but they should ponder them over the next few months.
The information, analysis, and opinions expressed herein are for general and educational purposes only. Nothing contained in this weekly review is intended to constitute legal, tax, accounting, securities, or investment advice, nor an opinion regarding the appropriateness of any investment, nor a solicitation of any type. All investments carry a certain risk, and there is no assurance that an investment will provide positive performance over any period of time. An investor may experience loss of principal. Investment decisions should always be made based on the investor’s specific financial needs and objectives, goals, time horizon, and risk tolerance. The asset classes and/or investment strategies described may not be suitable for all investors and investors should consult with an investment advisor to determine the appropriate investment strategy. Past performance is not indicative of future results.
Information obtained from third party sources are believed to be reliable but not guaranteed. Envestnet|PMC™ makes no representation regarding the accuracy or completeness of information provided herein. All opinions and views constitute our judgments as of the date of writing and are subject to change at any time without notice.
Investments in smaller companies carry greater risk than is customarily associated with larger companies for various reasons such as volatility of earnings and prospects, higher failure rates, and limited markets, product lines or financial resources. Investing overseas involves special risks, including the volatility of currency exchange rates and, in some cases, limited geographic focus, political and economic instability, and relatively illiquid markets. Income (bond) securities are subject to interest rate risk, which is the risk that debt securities in a portfolio will decline in value because of increases in market interest rates. Exchange Traded Funds (ETFs) are subject to risks similar to those of stocks, such as market risk. Investing in ETFs may bear indirect fees and expenses charged by ETFs in addition to its direct fees and expenses, as well as indirectly bearing the principal risks of those ETFs. ETFs may trade at a discount to their net asset value and are subject to the market fluctuations of their underlying investments. Investing in commodities can be volatile and can suffer from periods of prolonged decline in value and may not be suitable for all investors. Index Performance is presented for illustrative purposes only and does not represent the performance of any specific investment product or portfolio. An investment cannot be made directly into an index.
Alternative Investments may have complex terms and features that are not easily understood and are not suitable for all investors. You should conduct your own due diligence to ensure you understand the features of the product before investing. Alternative investment strategies may employ a variety of hedging techniques and non-traditional instruments such as inverse and leveraged products. Certain hedging techniques include matched combinations that neutralize or offset individual risks such as merger arbitrage, long/short equity, convertible bond arbitrage and fixed-income arbitrage. Leveraged products are those that employ financial derivatives and debt to try to achieve a multiple (for example two or three times) of the return or inverse return of a stated index or benchmark over the course of a single day. Inverse products utilize short selling, derivatives trading, and other leveraged investment techniques, such as futures trading to achieve their objectives, mainly to track the inverse of their benchmarks. As with all investments, there is no assurance that any investment strategies will achieve their objectives or protect against losses.
Neither Envestnet, Envestnet|PMC™ nor its representatives render tax, accounting or legal advice. Any tax statements contained herein are not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal, state, or local tax penalties. Taxpayers should always seek advice based on their own particular circumstances from an independent tax advisor.
© 2016 Envestnet. All rights reserved.