Regardless of near-term outcomes, U.S. inflation will have a difficult time breaking loose longer-term
There has been no shortage recently of alarmist headlines about U.S. inflation. Investors are concerned that after a long period of low inflation and strong market performance, rising prices could surprise investors and erode returns.
While inflation data and comments made following corporate earnings results have indeed pointed to higher prices, the magnitude and time horizon of this pattern are important to keep in mind.
In summary, the magnitude has been modest, and the timing is likely cyclical rather than secular. In fact, longer-term, several significant trends suggest persistently low inflation, or “stuckflation,” poses the greater challenge ahead. They include the following:
Reasons to Expect Stuckflation
According to the Congressional Budget Office, federal debt held by the public has doubled over the past decade and is expected to reach nearly 100% of GDP by 2028, at which point it will be higher than in any year since just after World War II.5
While long-term inflation headwinds are strong, knowing how to prepare may be less apparent, particularly at a time when some experts are stressing the dangers of inflation.
Here are some guiding principles to help:
Don’t Fear the Fed:
Inflation concerns are often raised in the context of monetary policy. The assumption is that higher inflation will lead the U.S. Federal Reserve (the Fed) to raise the Fed funds rate, which in turn will lead to higher interest rates and negative bonds returns. Keep in mind, however, that changes in the Fed funds rate have historically had a low correlation with bond returns6. This is not to say that bonds won’t experience losses in an inflationary environment, but worrying too much about the Fed’s next move is unproductive.
Don’t Fear Fixed Income:
Regardless of inflation outcomes, bonds play an important role in portfolios by dampening the volatility and downside risk of stocks and other higher-risk assets. Further, while a cyclical uptick in inflation and interest rates could cause unrealized bond losses, portfolios would likely benefit longer-term as coupons and maturities are invested at higher yields.
Don’t Abandon Your Plan:
The best defense against cyclical changes in the economic and market environment is a carefully crafted asset allocation aligned with your long-term goals. For many investors, this includes inflation-dampening investments, such as Treasury Inflation-Protected Securities (TIPS) and real assets (e.g. natural resources and real estate) to protect against both expected and unexpected inflation.
So let the pundits debate the near-term outlook for inflation. Most investors are better served by focusing on the long run, and protecting against – rather than reacting to – varying inflation outcomes.
- U.S. Department of Health and Human Services, Centers for Disease Control and Prevention. Health, United States, 2016. Life expectancy at birth. As of year-end 2015, the most recent data available.
- The World Bank. Fertility rate, total (births per woman) as of 2016, the most recent data available.
- Employment Projections program, U.S. Bureau of Labor Statistics.
- For more information, see our Portfolio Research paper, The Enigma of Fed Policy and Bond Market Returns.