• Investment Management

Equities Outlook 2017: Watch Out for Runaway Inflation

Will too much fiscal stimulus derail global growth? It depends on whether U.S. fiscal policy causes too much inflation and if the Fed has the power to contain it.

Stock investors have plenty of reasons to cheer. 2017 has been kind so far to global stock markets, thanks to a more stable China, a recovery in oil prices and the prospect of a significant fiscal stimulus program enacted by the new U.S. Trump administration1. After years of fretting about secular stagnation, investors are now worried they’ll miss out on a new bull market.

But the fiscal stimulus—especially of the amount President Donald Trump is talking about—will come with its own set of risks for investors to worry about, says Andrew Harmstone, lead manager of Morgan Stanley Investment Management’s Global Balanced Risk Control (GBaR) multi-asset strategy, with $8.5 billion2 of assets under management.

We need to watch whether President Trump stokes the economic engine with more stimulus than it can absorb.

“Our outlook for 2017 is upbeat over the near term,” says Harmstone. “But we need to watch whether President Trump stokes the economic engine with more stimulus than it can absorb. If he does, we could see inflation and recessionary pressures rise sooner than we’d all like.”

The U.S. ended with a 4.7% unemployment rate last December3, and there are reports that skilled workers might be in short supply in the U.S4. “If significant new fiscal stimulus is enacted, then the lack of skilled workers could easily lead to wage inflation,” he argues. “A year from now we may start to face the inflationary consequences of stimulating an economy that’s already near capacity.”

Can the Fed Contain Inflation?

It’s hard to imagine that, at an annualized 2.04% level, inflation could rise high enough to be a problem. If anything, central banks including the Fed have been praying for more inflation to pull them away from the brink of deflation. In theory, the anticipation of rising prices should prompt investors to buy goods now while they’re cheaper, and for corporates to gear up manufacturing to take advantage of higher revenue in the future.

A potential problem, says Harmstone, is whether the Fed has the ability to control inflation. “Even if the Fed is ready to act decisively when the economy is overstimulated, it’s important to note that the braking mechanism now available to the Fed is new and untested,” he says. 

He’s referring to whether the Fed will still be capable of controlling inflation the way it’s always done, by intervening in the daily money markets, to soak up excess reserves banks can lend out. These excess reserves are now at $2 trillion, because of all the securities purchased by the Fed as part of Quantitative Easing. Before 2008, the level of excess reserves was a mere $1.5 billion5.

“When the Fed drained these excess reserves prior to 2008, interest rates on whatever was left rose sharply and investment-led growth—and ultimately inflation—had to slow,” explains Harmstone. “With $2 trillion of excess reserves to manage, we may find that U.S. interest rates simply cannot go up enough to stop inflation.”

Consider Japanese and Emerging Market Stocks

Yet Harmstone adds that these are concerns for the latter part of 2017 and into 2018. “In the meantime, we find ourselves in a situation where US and global growth seem to be healthy, plus volatility has been low and sentiment is positive,” he says. “We believe we should remain healthily exposed to equities.”

Harmstone’s team likes the idea of taking unhedged Japanese equity exposure, as well as maintaining—and maybe even increasing—emerging market equity exposure.  “The emerging market stocks sell-off appears to have found a bottom and was not, in our view, entirely justified by fundamentals,” he says.

As for the U.S.?  The hope is that the realities of government will act as a moderating force, “increasing the likelihood of Trump’s measures still being stimulative but potentially less extreme.”