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The impact of inflation for investors ahead the March meeting of the Federal Reserve
14/03/2018 , Iain Tait, partner & head of the private investment office, London & Capital,

Delivering his first testimony as chairman of the US Federal Reserve, Jerome Powell indicated that the Fed is likely to continue increasing interest rates gradually to keep the economy functioning smoothly. Powell said the Fed would balance the need to guard against excessive inflation with the benefits of allowing the economy to enjoy the “tailwinds” of tax cuts and strong global growth. He also predicted that inflation would rise this year and stabilize around the Fed's two percent target. With a rate rise widely anticipated at the March Fed meeting, what will rising inflation mean to investors?
 
Conventional wisdom has favoured equities in times of raising inflation or when more importantly (as an earlier indicator) inflation expectations are increasing. This is due to the real asset nature of equities with company selling prices being used to pass on inflation while bond assets are eroded by rising inflation.

However, it is worthwhile taking a step back and assessing if inflation will actually materialise as there have been several false starts for inflation since the 2008 financial crisis. The evidence that inflation is picking up is not compelling by any means, in fact US wage inflation moved below three percent again for the last three months. Without wage inflation it is unlikely there will be sustained inflation given the vital role of consumption.
 
Given how far US 10 Year bonds yields have already moved especially given the Federal Reserve’s longer-term expectation for peak rates is only 3.1 percent and their favoured measure of inflation, PCE, has hardly moved and remains firmly below the two percent target, it seems too late to sell bonds now.  Conversely, the correlation between bonds and equities has moved to the uncorrelated stage of the cycle (the correlation between equities and bonds varies depending where we are in the economic cycle).
 
Between 2010 and the start of 2017 equity and bond markets were positively correlated. The next stage is likely to be that equities sell off on growth fears while bond markets recover some of the recent losses as markets have priced too much in for rates in the short term.
 
Equities also re-rate (high PE multiple) when inflation is falling and de-rate (lower PE multiple) when inflation is rising and this makes intuitive sense due to how the risk-free rate the theoretical rate of return of an investment with zero risk) is moving.
 
Therefore, it may be too late to buy equities and sell bonds on inflation concerns, this is the market now and it is getting close to topping out on this inflation hypothesis.



 

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