- Globalization, technology, and demographics have been helping to keep a lid on inflation.
- Continued low inflation could be a headwind for the performance of Treasury Inflation-Protected Securities (TIPS).
- Low inflation helps to justify above-average valuations for stocks.
In the wake of the financial crisis, the Federal Reserve kept rates low, waiting for unemployment to fall and inflation to rise to the Central Bank's long-term target. Several years ago, the unemployment rate passed the Fed's target, but despite some false starts, inflation has remained stubbornly low.
A few of Fidelity's fund managers weighed in to discuss why inflation has stayed low, why that trend may continue, and why that could pose a challenge for TIPS, while still supporting higher stock prices.
Unraveling the mystery of low inflation
Bill Irving, Research Director, Fidelity Global Asset Allocation
Most observers, including the US Federal Reserve, have been puzzled by the persistence of low inflation. Fed Chair Janet Yellen has often used the word "mystery" when describing the disconnect between improving US and global economic conditions on the one hand, and inflation that has been retreating from the Fed's 2% target during the past few months.
Part of the mystery is wage inflation. Historically speaking, inflation and unemployment have had a stable and inverse relationship: Economic growth has been accompanied by stronger jobs growth, lower unemployment, and, in turn, wage inflation, as well as broader consumer price inflation.
But wages have risen only very recently despite low unemployment. Year-over-year wage growth in the US accelerated 2.9% in September, while the unemployment rate fell below its previous 16-year low of 4.2%.
I have some doubts that wage inflation will accelerate enough from still-muted levels and be sustained enough to continually boost top-level inflation over the longer term. Granted, wages are likely to firm gradually over the shorter term. Beyond that, a number of factors may continue to anchor inflation and prevent it from rising further. Younger and part-time workers, who typically earn lower wages, are moving into the full-time workforce, as higher-paid Baby Boomers exit. I also believe US wages are ultimately constrained by globalization. Companies can move substantial numbers of jobs anywhere in the world where labor is cheap.
As for consumer inflation, there are some crosscurrents, but I don't foresee a major pickup. Tighter labor markets and somewhat higher wages support gradually rising core inflation. But shelter costs (roughly 40% of core inflation measures) are slowing, along with a surge in new multifamily housing units. Other transitory factors, such as one-time discounts for wireless phone service will, in my view, likely weigh on inflation in coming months.
I believe the performance of TIPS will depend on interest-rate policy and inflation trends. Further potential Fed rate hikes will occur to the extent that the economy continues to strengthen and inflation accelerates. While rate hikes would likely be negative for government securities, I believe the hikes would most adversely affect short-maturity bonds rather than long-maturity bonds, in particular yields on longer maturity TIPS may remain low.
Although TIPS have been out of favor during the past year, my view is that they were fairly valued versus straight Treasuries as of November. I also believe they can provide investors effective hedge against inflation over the longer term.
Low inflation may help justify stock valuations
Mark Notkin, Fidelity® Capital & Income Fund (FAGIX)
There are a lot of different theories as to why we are not seeing higher inflation. In my opinion, much of it has to do with technology, the internet, e-commerce, and automation—all of which have been and will continue to be highly deflationary, particularly as they relate to wages. As an example, think about Amazon.com and its ability and willingness to offer very low prices. That kind of competition limits the ability of companies to raise prices for consumer, and therefore wages.
Other factors include commodities prices remaining low overall, especially oil prices, which have remained in a reasonable range during recent years. And there's not a lot of reason to believe we are going from US Treasury yields at 2.3% back to 4% to 5% any time soon. Also keep in mind that the ongoing rally in stocks is partly due to strong fundamentals, as measured by corporate earnings.
In general, as I see it, low inflation is good for most asset classes. In particular, because many stock valuation approaches use interest rates to discount future earnings, future earnings appear more valuable in present terms when rates are low.
So how does low inflation affect how I manage my fund? I am confident in saying that it gives me some comfort that higher historical stock valuations are justified, and as long as rates and inflation stay low, stocks will continue to offer good relative value compared to investment-grade and high-yield bonds.
Few companies retain pricing power
Sammy Simnegar, Fidelity® International Capital Appreciation Fund (FIVFX)
In my view, low global inflation reflects the difference in the way the US and Europe recovered from the 2007-2009 financial crisis. Here in the US, the down cycle was fast and furious, as was the economic recovery. In contrast, Europe experienced a double-dip recession, requiring about 3 more years of economic stimulus (quantitative easing, or QE) for things there to begin picking up. Today, growth in Europe is looking much better, but still remains below longer-term trends, which is why the European Central Bank is still applying QE and plans to do so until it sees stronger inflation figures.
I see the below-target US consumer price index (CPI) as a reflection of the still-recovering global economy. That said, low inflation is a small problem relative to having unwanted inflation, which I think is by far the greater risk. In fact, I would be somewhat concerned about equity markets if I were to see crude-oil prices rise above $60 and stay there. To me, that would be an early sign of rising inflation, since oil prices tend to lead CPI and PPI (producer price index) figures by a few quarters.
In my view, any higher inflation would be felt mostly by producers in this economy, rather than consumers, which would result in lower corporate profits rather than higher consumer prices. This is because a lot of companies have lost their pricing power. Think about shopping for a new Nerf® toy for a youngster. You used to go straight to your local toy shop and pay whatever the store charged. Now, in a matter of minutes, you can check various internet sites for the best price and have the gift delivered. Also, the just-in-time inventory systems used by today's online sellers and many big-box stores help to cap inflation, since they all but eliminate the periodic shortages of goods that can drive consumer prices higher.
For this reason, I believe that some of the only companies that still retain strong pricing power are sellers of luxury goods—think of LVMH Moët Hennessy Louis Vuitton or Switzerland's Richemont, owner of the Cartier® brand. Customers will pay up for merchandise with these names.
All in all, I think the current scenario—very low inflation that may be a little less than anticipated—may not be perfect, but on the whole it's a fairly good one for both equity investors and consumers.
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