• Wealth Management

Don’t Shrug Off Rising Inflation

Consumer prices are heading higher and investors may be too complacent about the risk that could present to markets.

I’ve been worrying for a while now that markets are too complacent about an assortment of risks. Higher inflation is one I’m particularly focused on now.

Fresh economic data suggests that price increases are accelerating. Not only have some key inflation measures matched the Federal Reserve’s 2% target, but some measures are now exceeding that level.

In June, the Producer Price Index, which tracks inflation at the wholesale level, rose faster than expected, posting year-over-year growth of 2.8%. Consumer prices showed similar strength with year-over-year growth of 2.9% for the main measure, and 2.3% when more volatile food and energy prices are factored out. The New York Federal Reserve’s Underlying Inflation gauge is running at 3.33%. The data paint a clear picture of an upward trend.

These gains came before the potential impact of trade tariffs and sanctions—which typically result in higher prices. That means the rise in inflation may well get worse.

Why are markets complacent?

Investors seem to be looking past the economic data, predicting that global growth will slow (partly due to trade tensions) and that the Federal Reserve won’t be as aggressive about raising rates as it has recently indicated. The yield on the benchmark 10-year Treasury note, which normally rises when inflation expectations increase, peaked in May at 3.11% and has since fallen back to 2.85%.

I think the markets may be missing some key points. First, oil prices, which have slipped back recently, may resume their climb due to supply constraints. Wage growth, which has been surprisingly restrained given the tightness in the labor market, could be about to accelerate. Finally, Washington policies could add to inflation pressures. These policies include potential tariffs, a jump in deficit spending, and efforts to roll back the Affordable Care Act, which may already be leading to a recent rise in health care costs.

Bottom Line: If inflation keeps rising, the Fed is likely to respond by raising interest rates, even if growth is slowing, a condition known as stagflation. Last week I suggested investors rebalance their equity portfolios away from this year’s winners and into more defensive sectors. On the fixed-income side, I think investors should avoid longer term bonds (which tend to fall in price when interest rates rise) in favor of shorter term bonds and cash.