The good and bad of rising inflation

Brexit happened. Trump happened. Several major events shocked global markets last year. Now investors are considering the possible long-term effects of those events and wondering what to expect in 2017. What are some of the changes investment experts are predicting? While there are a handful – think factors like taxation, interest rates, fiscal stimulus and inflation – here I’ll focus on inflation.

We’re starting the year with relatively low unemployment, upward pressure on wages, and strengthening GDP growth, which we believe create a strong platform for the economy. President Trump’s administration is proposing large tax cuts and new infrastructure spending. That will likely boost growth and drive prices higher. As a result, experts are predicting U.S. inflation will continue to rise. What could an increase in inflation mean for the market?

When considering the possibility of rising inflation, it’s important to remember inflation is not always a bad thing. Certain levels of inflation can have a positive impact on the market. How? Rising prices often force customers into action. People tend to buy now with the expectation that prices will continue to move higher. Then demand increases so companies produce more. And eventually those companies are rewarded with higher profits.

Certain levels of inflation are also good because rising prices tend to lessen the fear of prolonged deflation. What’s wrong with a fear of prolonged deflation? When consumers fear prolonged deflation, they tend to delay spending with the expectation that prices will continue to fall. When this happens, demand falls and companies sell less. This can eventually lead to layoffs. When the unemployment rate goes up, wage growth goes down and workers ultimately have less money to spend. In response, companies lower their prices and the deflationary cycle continues.

There is a point though, where a certain level of inflation may begin to negatively impact the market. Research suggests that shift from good to bad happens when the inflation rate is around 3 to 4 percent:

 

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When inflation hits 3-4 percent, companies may raise their prices and banks may raise interest rates to maintain profitability. Higher interest rates can contribute to tighter financial conditions and borrowing can become more difficult. The strain on businesses may cause some to fail. Eventually, unemployment may rise and economic growth can begin to slow.

So, in 2017, how much do we expect inflation will rise? Will we experience good inflation or bad inflation? Our target date portfolio management team doesn’t anticipate an inflation spike in the near future. We do believe inflation will rise, but anticipate core inflation will return to a level consistent with the long-term, good trend of about 2.5 to 3 percent.

We do anticipate other, unexpected changes in 2017. We don’t know yet which of President Trump’s policies will be put into place. There’s been a general absence of inflationary pressure since 2012, and it’s a low interest rate environment. The combination of these factors increases the likelihood for unexpected change in the near future.

What does all of this mean for our target date portfolios? In today’s environment, based on our recent research, we expect Treasury Inflation Protected Securities (TIPS) will likely underperform other asset classes in this market because of their long duration. So we’re lightening up on core fixed income and increasing our weight to limited term bonds. We’re also increasing our exposure to less rate-sensitive real assets. Although sluggish global growth makes it unlikely that we’ll experience a renewed commodity super-cycle, eliminating excess supply in key sectors within the commodity space could lead to modest price increases in the months ahead.

If inflation ticks higher than expected, and into the 3-4 percent range (or even higher), we’ll adjust our portfolios accordingly. Most importantly, we want to provide the expertise investors need to help them stay on track for their long-term goals, regardless of any unexpected change that might happen this year.

 

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