Inflation remains close to historic lows, not just in the United States but also in other large developed markets.
Last week, we got more evidence of this with news that U.S. import prices fell 0.7% in October and are now down 2% from a year earlier. And on Wednesday, the Bureau of Labor Statistics will report October’s consumer price inflation, which is expected to fall to around 1%, a low reading even by the diminished standards of the past four years. Similarly, outside of volatile food prices, inflation in other large, developed countries is running around 1.5%, with inflation in both Europe and Japan even lower.
As I write in my new weekly commentary, there are three big reasons for the lack of developed world inflation:
1. Low wage growth. Last week, the Bureau of Labor Statistics announced that unit labor costs in the United States actually fell at a 0.6% annualized pace in the third quarter. As long as there’s considerable slack in the labor market, wage costs will remain contained.
2. Excess capacity. There is a fair amount of slack capacity in U.S. factories and utilities. Capacity utilization – how much of our factories, utilities and other capital stock is being used – remains depressed. Practically this means few factory bottlenecks and little upward pressure on prices.
3. Slow credit growth. While the Fed has expanded its balance sheet, banks have not been lending aggressively. With credit growth slow, growth in the money supply is also muted.
Assuming this is the environment we’re in for 2014, there are two investment implications:
1. Low-for-longer rates will support stocks. While the Fed is likely to start to taper at some point in the next several months, short-term interest rates should remain anchored at zero throughout 2014, and potentially much longer. Low short-term rates will continue to support stocks by keeping margins and valuations higher than they would otherwise be.
2. Consider underweighting Treasury-Inflation Protected Securities (TIPS). I still don’t advocate increasing exposure to inflation hedges, particularly if those hedges are expensive. The lack of inflation is one reason that TIPS have underperformed so dramatically year-to-date. And despite the losses, this asset class, particularly long-dated TIPS, is still not cheap. Finally, while TIPS hedge against inflation, they’re vulnerable to rising real rates.
To be sure, none of this suggests that inflation won’t eventually pick up. But for now, to the extent we remain in a world characterized by slow wage growth, excess capacity, and modest credit creation inflation is likely to remain low, at least for the next year or so.
Sources: BlackRock Weekly Commentary, Bloomberg