FICS Editors' Note

Inflation rose at a 2.2% annual rate in the fourth quarter, the government reported Friday — the highest reading for the personal consumption expenditure (PCE) price index, the Federal Reserve's preferred measure of inflation, since 2012.

Straight talk about inflation and the markets

History tells us that as inflation accelerates, share price gains don't keep pace.

• BY JAMES MACKINTOSH, 
• THE WALL STREET JOURNAL 
• – 01/26/2017

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Inflation is on the up, and shareholders are delighted. The post-election reflation rally was predicated on the new president's promise to reflate the U.S. economy with big fiscal spending, putting a booster under expectations for inflation that were already moving skyward.

So far the "Trumpflation" trade has run exactly as would be expected: Shares have risen, bond prices have tumbled (as yields have increased) and the values of the longest-dated bonds have been eviscerated. Investors have waved goodbye to deflation fears and embraced higher inflation.

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For the moment, that looks like a rational response to the assumption that President Donald Trump's policies herald higher inflation. But shareholders should be keeping a watchful eye on consumer prices, as they often rise much faster than anticipated. Like alcoholic drinks (prices of which are up just 1.4% in the U.S. in the year to December), too much of a good thing can have nasty aftereffects.

The basic effects of inflation are well-established: Higher inflation means weaker real, or inflation-adjusted, returns from shares. Put another way, as inflation accelerates, share price gains don't keep pace. The ideal for investors is steady, reasonably low inflation; just enough to keep deflation worries away, but not so rapidly that the central banks will have to jack up interest rates quickly.

Richard Turnill, chief investment strategist at BlackRock Investment Institute, says higher inflation is supportive of corporate earnings despite higher wages, because those wages are spent. But he says it can push down the valuation of those earnings, and since share prices are the result of the earnings times the valuation multiple, that can offset the higher profits. "This tips from good reflation to bad reflation when the central banks really have to tighten and you start to worry about how far away the next recession is," he said.

Every cycle is different, but in the past there often has been a break in markets when inflation hits 4%.

"If inflation gets to 4% the Fed's really behind the curve," says Jason Trennert, chief investment strategist at Strategas Research Partners. "The good news is that we probably have some time before we get to 4%."

It would be misleading to say 4% inflation is guaranteed to be the point where the market going gets rough.

Yet, that level has often been a decent warning signal. In 1987, for example, inflation hit 4% in August and the market crashed in October. In 2000, the dot-com bubble burst with inflation at 3.75%, while stocks hit their pre-crisis peak in October 2007, the month before inflation broke through 4%.

It is easy to forget inflation can be that high. Consumer-price inflation in the U.S. is just above 2% at the moment and hasn't been above 4% since 2008, while the Federal Reserve's preferred personal consumption expenditure (PCE) measure is a little below its 2% target. Friday will bring figures for the fourth-quarter PCE which aren't expected to rise much, and investors are now pricing in U.S. inflation being broadly on target in the long run.

Inflation hurts valuations

There's a sweet spot of inflation when stock valuations tend to be high, and we're in it today. Valuations have typically been lower when inflation is above 4%.

Source: Thomson Reuters

The inflation rate implied by Treasury bonds for the five years starting in five years' time — a gauge designed to strip out near-term fluctuations — is up from a post-recession low of 1.4% in July to 2.2%. That would equate to PCE inflation almost exactly on target, suggesting few concerns about an overshoot.

Yet, in the past, inflation has rarely paused at 2%. Since Paul Volcker's Fed tamed the monster inflation of the 1970s, it has risen back through 2% a dozen times, including in December. A year after each of the previous 11 instances it had jumped to 4% twice, and above 3% four times.

Maybe this year will be like October 2002, the only time inflation was still at 2% a year later (although it did briefly jump to 3% in between.) But there has to be at least a decent chance that inflation overshoots.

If inflation does carry on up, history suggests that the price/earnings ratio will suffer, as the sweet spot for valuations has been with inflation in the range of 1% to 3%, and they have on average fallen sharply with inflation above 4%. Given that the market starts out already very highly valued compared with the past, the danger is that a sharp drop in valuation will more than offset the rise in earnings from a stronger economy.

This time might be different, if Mr. Trump's plans for corporate tax cuts and a bonfire of red tape boost earnings enough to mean that any drop in valuation doesn't matter. After a seven-year bull market and with valuations high, many fear the end can't be far away, but the rosy scenario is that Mr. Trump can take us back to 2005. A year after the Fed started raising rates, inflation broke 4% and the valuation of the S&P 500 began to drop. But earnings rose quickly enough to allow shares to carry on up for months before a brief pullback in 2006 — and then, as inflation dropped, to have a final run that took them up another 25% before the credit crunch hit in 2007. Just hope that we have learned enough to avoid a repeat of what followed.