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Inflation May Finally be Happening. Now What?

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December 1, 2016
Market inflation and current treasury bond yields.
DaniloAndjus/Getty Images

Finally, inflation is making its presence known in the U.S. economy again. Like a long-awaited dinner party guest who has been very late to the table, inflation may be arriving just in time for dessert.

The current economic expansion phase began in June 2009, yet inflation has been minimal throughout this recovery period. “The change in the consumer price index has been less than 2.5% in this millennium versus a rate of 3% - 7% during the 1970's-1990," says Sam Stovall, chief investment strategist at CFRA. 

That may be starting to change. The latest U.S. Consumer Price Index, issued by the Bureau of Labor Statistics, revealed that total CPI is up 1.6% in October, while the core rate climbed 2.1% year-over-year.

"The Fed has been wishing for inflation for quite a while. It would be good for the economy to see some inflation," says JJ Kinahan, chief market strategist at TD Ameritrade. Inflation has been one of the factors holding the Federal Reserve back from interest rate hikes in 2016, as the data has remained below the central bank's target at 2%.

Time To Talk To Your Boss About That Raise?

As inflationary pressures remained low in recent years, wage growth has also been capped. It has been a long time since many Americans got a raise. Now, one of the factors helping inflation to tick modestly higher has been the emergence of wage growth. The October average hourly earnings data revealed a 0.4% rise, which translates into a 2.8% rise for the 12-month period.

The fear is that the inflationary pressures "hit all at once," Kinahan says. Quick wage growth can lead to inflation. "If we start to see 0.8% and 0.9% gains in wage growth that could quickly lead to inflation" throughout the broader economy, Kinahan explains.

Are Markets Signaling a Jump In Expected Inflation?

The Treasury bond markets can be notoriously good at sniffing out inflation expectations, and the recent jump in 10-year yields has surprised some analysts. Since Nov. 4, the yield on the 10-year Treasury note has surged from 1.77% to over 2.30% -- a significant move in such a short period of time.

The concern for financial markets is whether "we get a bunch of inflationary pressures all at once," Kinahan warns.

The big move in Treasuries is tied in part to the recent presidential election results. "Investors are reacting to proposals that the Trump administration could inject some octane into economic growth primarily through infrastructure spending, which could end up being inflationary," says Stovall.

But are the markets putting the cart before the horse? "We don't really know whether a very conservative Congress would be willing to approve these proposals. Congress has been saying it wants to reduce the overall debt levels," Stovall adds.

Add Inflation Data To Your Watch List

Inflation simply hasn't been a concern for the stock market or investors in recent years, but now Kinahan says it is important for investors to monitor the data. There are a number of key inflation gauges that can be important to follow, including the Consumer Price Index, the Producer Price index and the Fed's preferred inflation gauge, the Personal Consumption Expenditure. These inflation measures were highlighted in a recent article on The Ticker Tape.

TD Ameritrade clients can study historical inflation trends via the FRED charting tool. See Figure 1 below for a look at historical CPI data. 

Monthly CPI, 1987-2016

FIGURE 1: MONTHLY CPI, 1987-2016

TD Ameritrade clients can access this tool via the thinkorswim® platform by TD Ameritrade. To access, click the Analyze tab and select the Economic Data subtab. Source: FRED database, St. Louis Fed.  Not a recommendation. For illustrative purposes only. Past performance does not guarantee future results.

Investors: Take Your Time With Portfolio Shifts

If inflation were to jump sharply higher, certain stock market sectors may be impacted. "If you see inflation pressures come in stronger, people will still buy groceries, but consumer discretionary will be affected. People have to make choices—especially if inflation starts to outpace wage growth and they might not buy that expensive sweater," Kinahan says. 

Stovall points to sectors including energy, technology and materials as late-cycle performers that can benefit from a rapid increase in inflation, as shown in figure 2 below. 

Sector performance in rising CPI environment, 1970-2016

FIGURE 2: HOW HAVE SECTORS PERFORMED IN A RISING INFLATION ENVIRONMENT?

Data source: CFRA, NAREIT, BLS.  Not a recommendation. For illustrative purposes only. Past performance does not guarantee future results.

For investors who are attempting to structure portfolio shifts ahead of the new administration, Kinahan advises, "Take a step back. Wait to see what happens. Nothing is set in stone yet. You don't need to be the first one at the party; you can observe for a while."

Stovall warns that a sharp jump in inflation may not come to fruition. "Investors are getting ahead of themselves regarding how much stimulus will be injected into the economy. I don't think a sharp uptick in inflation will become a reality," Stovall says. Nonetheless, "a low point in inflation has likely been seen and the new trajectory is higher." 

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