For years, the markets ignored inflation. Not anymore.
Inflation may not be a major preoccupation — at least not yet — but it’s back as a real concern.
“It wasn’t too long ago when all we were concerned about was deflation,” said Henry B. Smith, co-chief investment officer at the Haverford Trust Company. “Right now, what we’re seeing is a transition to a normalization of inflation.”
For investors who’ve been worrying more about deflation — falling prices — for the last decade, even “normal” inflation may feel foreign, Mr. Smith said.
Recently, inflation has definitely ticked upward. The Consumer Price Index rose 2.9 percent over 12 months through June, its biggest increase in six years. That’s still below the long-term average of 3 percent. Yet a year ago, consumer prices were growing at a 1.6 percent annual rate. And 12 months before that, inflation was just 1 percent.
The changes are striking even for producer prices, which reflect the wholesale cost of raw materials. The Labor Department reported that the Producer Price Index rose 3.4 percent in June, the largest increase in more than six years.
Mark R. Freeman, chief investment officer for Westwood Holdings, said he wasn’t necessarily worried about inflation growing out of control in the near term, because wages aren’t soaring. In June, average hourly wages for all employees in private-sector nonfarm jobs rose to $26.98, a 2.7 percent increase over the last year.
Still, he said it’s more likely that inflation pressures will grow than shrink, “especially if you have things like tariffs come into the picture.” A move away from free trade could reverse the disinflationary effects that globalization has had in recent decades, he said.
So as inflation becomes part of the normal environment again, he said, “investors should be normalizing their portfolios along with it.”
That needn’t entail big changes overnight.
Areas that were traditionally sensitive to inflation haven’t been affected much, at least not yet. Mutual funds and exchange-traded funds that specialize in precious metals lost 5.6 percent, on average, over the last year, according to Morningstar. And funds that specialize in real estate — which tend to rise when inflation does — returned a mere 3.9 percent over the last 12 months.
But it may make sense for investors to assess their comfort with their overall mix of stocks and bonds.
“None of the numbers look particularly shocking, but inflation has been steadily inching higher month after month,” said Ben Inker, head of asset allocation for the investment firm GMO. “I would think that the bond market should be a little more scared of this than it is,” he said, as rising inflation and the corresponding rise in interest rates weigh on bond prices.
Mr. Smith of Haverford agreed. “If this is truly a normalization of inflation, then that would pressure fixed income more than equities,” he said. “Our view is that within whatever range for stocks that investors believe they can tolerate, they should have maximum exposure to equities.”
He said investors ought to tilt their stock portfolios slightly toward economically sensitive areas of the market to ride the tailwind of economic growth that is propelling inflation. Those sectors include industrials and technology.
“At the margins, we’re putting a little more into playing offense, with names like Honeywell (HON) and FedEx (FDX),” he said.
Though Honeywell is a giant industrial conglomerate, it has been growing four times as fast as its peers in terms of earnings over the last five years, according to Zacks.com. That has been helped by Honeywell’s push into industrial automation and internet connectivity.
FedEx is another beneficiary of the accelerating economy in the short run as well as long-term growth — in this case, from e-commerce. But the express delivery giant could benefit from rising inflation for another reason.
Historically, low inflation has usually coincided with higher valuations in the stock market, as price stability offers companies a greater margin of safety. Yet as inflation heats up, the price that investors are willing to pay for every $1 of corporate earnings has tended to fall.
Since 1958, the average price/earnings ratio for stocks when the inflation rate has been 2 to 3 percent has been 17.6, according to an analysis by Charles Schwab. But once inflation is between 3 and 4 percent, P/E ratios have historically fallen nearly 10 percent.
At FedEx’s current price/earnings ratio of 14.3, the company’s shares aren’t just trading below the market average, they are at a 47 percent discount to the company’s five-year average, according to Morningstar.
Stocks known for reliable dividends
Another strategy is to look for stocks that aren’t just growing faster than inflation but that also have a track record of passing on that growth to shareholders in the form of dividends.
What you want is to own companies that have the ability to grow their dividends in excess of the rate of inflation,” Mr. Freeman of Westwood Holdings said. These so-called dividend growers can be found, he said, among companies whose profits are rising faster than the market as a whole.
“Microsoft (MSFT) has been the poster child of that over the past decade, thanks to their steady, significant earnings growth,” Mr. Freeman said. And over the last eight years, the stock’s dividend payout has grown 15 percent annually.
James Paulsen, chief investment strategist for the Leuthold Group, said investors shouldn’t restrict themselves to giant companies. Mr. Paulsen said that historically, large stocks have actually thrived in periods when inflation has been slowing, not accelerating.
Smaller companies, on the other hand, can often thrive in an inflationary time. “Small companies are run more lean and mean, with narrow margins,” Mr. Paulsen said. As a result, if their revenues were to increase because of a modest rise in prices, that would have a bigger impact on their profits than it would for much larger businesses.
In the recently ended quarter, small stocks have outpaced larger ones by a wide margin. The Russell 2000 small-company index (.RUT) returned nearly 8 percent in the quarter, compared with 1 percent for the Dow Jones industrial average (.DJI), which contains big companies.
The recent small-stock outperformance may derive from fears over the impact of a trade war with China on big, trade-oriented companies. Small stocks tend to be more resistant to tariffs because they are usually domestically oriented. But Mr. Paulsen said investors should not underestimate inflation’s effect on this recent trend.
“It’s no coincidence that the peak for small-stock outperformance was in 1983,” he said, when inflation was finally being brought under control after a huge increase in the 1970s.
More recently, Mr. Paulsen pointed out: “The best period for small stocks was in the early 2000s, when commodity prices were booming.”
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