By Michael Brush, MarketWatch
Justin Sullivan/Getty Images
We’ve had “deflation” drummed into our heads for so long, while oil and commodities have been in such a nose dive, that many investors don’t even question whether prices will ever go up again.
They just won’t.
That’s why as inflation revs up in the coming year, a lot of investors are going to be caught wrong-footed. Don’t be one of them.
“Investors should prepare for a cascade of change in the character of the financial markets,” cautions James Paulsen, an economist and strategist at Wells Capital Markets.
It’s already under way. Repositioning for inflation explains much of the recent stock market turbulence, because some investors get it.
To be clear, Paulsen is not predicting runaway inflation. But even persistent higher inflation will rock investor mentality, because a lot of money managers just aren’t expecting it. I know this from talking with investors on a daily basis. But you can also tell because the yield gap between 10-year U.S. Treasury bills and inflation-protected treasuries (TIPS) is relatively narrow. If investors were expecting lots of inflation, they’d be selling bonds, which would raise those yields compared with returns on TIPS.
Here are five reasons why investors have it wrong about inflation. After that, we’ll look at how you should position now — including several stocks to buy and things to avoid — to prepare for the inflation-induced cascade of change to come.
Reason 1: Investors are looking at the wrong inflation
Some basics: There’s “headline” inflation, and there’s “core” inflation. Headline inflation includes food and energy. Core excludes them because they are volatile. Lots of investors are focused on the headline Consumer Price Index (CPI), which looks relatively tame at 1.4%, since it’s pushed down by weak oil and commodities.
But this is where investors go wrong. Because core inflation matters, and it’s ramping up. Core CPI recently hit 2.2%, just about the highest level during this economic recovery. That’s a lot higher than headline inflation of 0.4%.
But oil is rising, and it will probably continue to do so. So are commodity prices, which could push food prices higher. By the end of the year, all of this could push headline inflation — the measure that’s currently lulling investors — up to 3%, says Paulsen.
“All of the sudden, headline inflation is higher than core inflation, and that is going to be huge,” he says.
Reason 2: Bernie Sanders may be a nice guy, but he’s wrong about wages
Because there’s a presidential election, we hear a lot these days from Bernie Sanders and others about wages being stagnant for years. Sorry, Bernie, but this is just plain wrong.
Wages have been going up throughout the recovery, and indeed since the mid-1990s, says Paulsen. But pay growth accelerated last year. Median wage growth calculated by the Federal Reserve Bank of Atlanta rose 3% over the past year, points out Robert W. Baird investment strategist William Delwiche. That makes sense, because the number of jobs available has been going up. So employers have to pay more to hire workers.
This wage growth will bleed through to prices as consumers buy more and companies raise prices to pay workers more.
Reason 3: Investors are fooled by sluggish growth
A lot of the time, inflation is associated with raging growth. So investors question how we could have inflation with just 2.5% GDP growth. The answer: It’s not really the overall rate of growth that matters. What matters more is whether supply is tight. That’s what we have now in the labor market with unemployment below 5%. This means wages can heat up even more, causing more inflation.
Sure, there was a big pool of “discouraged” workers. But people outside of the work force have been coming back in droves since September, upping the labor participation rate. So far, this has covered a lot of the demand. But those days are about over, according to an analysis of the sources of these new workers by Goldman Sachs economist David Mericle.
“The sources of workers, like retired, may have given up as much as they can,” he says. Mericle predicts the job market participation rate will actually decline. That will make the labor market even tighter.
Reason 4: The dollar is going to weaken
Many investors think higher U.S. interest rates, as the Federal Reserve raises its benchmark rate, will attract foreign investment and push the dollar higher. But what if rate cutting and other stimulus in Europe, China and emerging markets works, sparking growth in those regions? That’s going to attract investment money there, and drive up those currencies against the dollar, pushing the dollar lower.
The upshot will be inflation, since a lower dollar often drives up the prices of commodities and oil.
Reason 5: The markets are telling you inflation is on the way
Sectors that do well when there’s inflation — such as transportation and materials — have all been doing well recently. So have emerging market stocks, which benefit from inflation because of their exposure to commodities and manufacturing. Gold has been going up, and so are Treasury yields.
Groups to own and avoid: The 30,000-foot view
If surprise inflation is on the way, you want to own sectors and things that benefit. This includes: commodities, real estate, hard assets, materials companies, and industrial and transportation companies, which benefit from higher selling prices. Also consider small-cap companies. They’re leaner than large-cap companies, so higher prices bring superior earnings leverage. And foreign companies, because they have greater exposure to the industrial sector and commodities. You want to avoid bonds (unless you plan to hold to maturity from the outset), and bond-like stocks, meaning dividend payers.
I checked in with a few money managers, and here are some individual stocks they say would benefit from rising prices.
These will do better because they own a lot of hard assets, which go up in value when there’s inflation, says Eric Marshall, a portfolio manager and director of research at Hodges Capital Management. The higher prices also make it costlier for competitors to come in.
“It creates a barrier to entry,” he says.
He likes Martin Marietta Materials Inc. (NYS:MLM) , Vulcan Materials Co. (NYS:VMC) and Eagle Materials Inc. (NYS:EXP) . They’ll benefit from inflation, even if Marshall doesn’t actually buy my inflation thesis. He likes these because they will benefit from the $305 billion, five-year highway bill signed into law in December. It’s the first long-term highway bill in a decade. So long-term projects held back by the uncertainty of past, temporary bills will get bid out.
Agricultural commodities will rise in price with inflation, pushed along by a weakening dollar. This will help producers and farm-equipment companies. A weaker dollar will also make it easier for U.S. farm-equipment companies to export, points out Marshall. He favors Deere & Co. (NYS:DE) , AGCO Corp. (NYS:AGCO) and Archer Daniels Midland Co. (NYS:ADM) .
Higher inflation will drive up long-term bond yields, steepening the yield curve. It will also force the Federal Reserve to raise interest rates faster, which would drive up yields, too. All of this will help banks, because they tend to lend at the longer end of the yield curve, and borrow (take deposits) at the short end. This will improve the difference between the two, called net interest margin (NIM).
“The spread between short and long rates has been very narrow. The whole sector has been under NIM compression,” says Brian Smoluch a co-portfolio manager at Hood River Small Cap Growth Fund (NAS:HRSRX) .
His fund gets a five-star rating from Morningstar, and it beats competing funds by over 3 percentage points, annualized, over the past five years.
“So if the Fed raises rates, banks can price their loans higher, and there is a lag effect on them taking up their deposit costs. So their NIM will rise.”
Smoluch favors Bank of the Ozarks Inc. , where commercial real estate lending strengths have helped loan growth surpass 40%. He also likes Webster Financial Corp. (NYS:WBS) , which has a low-cost funding base because it collects a lot of deposits via health-savings accounts; and First Interstate Bancsystem Inc. (NAS:FIBK) in part because it has room to cut costs and improve fee income.
Land is the ultimate inflation hedge. Since it can be tough to buy land outright as an investment, consider shares of Texas Pacific Land Trust (NYS:TPL) , says Marshall, at Hodges Capital Management. It owns about 900,000 acres in Texas. It collects oil and gas royalties from the property, so it should benefit from higher energy prices, too.
At the time of publication, Michael Brush had no positions in any stocks mentioned in this column. Brush has suggested ACGO in his stock newsletter Brush Up on Stocks. Brush is a Manhattan-based financial writer who has covered business for the New York Times and The Economist group, and he attended Columbia Business School in the Knight-Bagehot program.