Believe it or not, the spectre of inflation will once again rear its ugly head, one veteran portfolio manager warns advisors.
“To us, the biggest surprise for investors in 2016 very well may be that inflation once again becomes a significant investment risk, particularly if the energy markets stabilize or move higher,” wrote Eaton Vance portfolio manager Stewart Taylor for Wealth Management.com. “Unfortunately, many investors are poorly positioned to protect the purchasing power of their savings and investments if inflation surges.”
Stewart points out that many have been blinded by the sharp decline in energy and commodities prices which has kept CPI very benign and lulled many into a false sense of security. Lurking below the surface, Taylor suggests, is service inflation which is on the rise.
“It is that weakness that has masked the upward trend in services inflation,” wrote Taylor. “For instance, in the October CPI report, core services (58 percent of headline CPI) grew at a 2.8 percent year-over-year (YOY) rate. To us, it appears the worst of the energy and commodities bear markets now appear to be past.”
So, with services inflation moving ever higher — e.g. retail prices in Canada have increased steadily in 2015 due to a weak Canadian dollar — and oil prices hitting a bottom there’s only one way for them to go and when that happens inflation is off to the races.
Even more relevant to Taylor’s argument is the fact wage growth in the U.S. is finally happening.
“Year-over-year average hourly earnings (AHE) have touched 2.5 percent for the first time in six years,” Taylor wrote. “In past cycles, as AHE’s breach 2.5 percent, the trend accelerates and remains in place for two to three years.”
So, what should advisors be doing at this point?
Our economic situation is much more dreary than south of the border and arguably less vulnerable to rising inflation. But that doesn’t mean you shouldn’t be positioning clients for the inevitable push by inflation here in Canada.
“Given the nearly 8% weight that energy holds in the CPI basket, a move higher in oil (for example, to $51 per barrel over the next year) would push headline YOY inflation near 3 percent,” wrote Taylor. “In other words, to keep inflation at the current benign year over year levels it would take another sharp leg lower in energy.”
Taylor feels that there isn’t enough inflation priced into the Treasury markets at the moment providing investors with opportunities in inflation-linked assets.
“In the scenario outlined above, floating-rate and real-return investments would be expected to perform well, while negative real returns (the return when adjusted for inflation) on fixed-income investments with a fixed rate and maturity become more likely,” Taylor writes.