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What Rising Inflation Expectations Could Mean for Your Portfolio

While global reflation has lifted markets over the past few months, muted or slowing economic growth could create challenges for investors.

A little inflation can be good for equities, but when it appears absent from economic and earnings growth—a condition known as stagflation—it can complicate the market outlook for investors.

Current rising inflation expectations, a byproduct of global monetary stimulus and easier financial conditions, are part and parcel of a period of global reflation that has lifted markets in nearly a straight line since last September. The 10-year “breakeven rate,” a measure of inflation expectations based on comparing the yield on the 10-year Treasury with a 10-year Treasury Inflation-Protected Security, has climbed from a low of 1.47% last October to 1.8% currently.  

Yet, that tailwind could soon become a headwind. I can envision a scenario emerging in 2019 that features middling U.S. growth, weak corporate earnings, and rising inflation, amid higher commodity costs, wages, and a weaker dollar. The recent spike in oil prices following rising geopolitical risk in the Middle East is a reminder of how quickly market sentiment can change. 

A more positive global reflationary scenario may carry the day, but investors should take note of some market trends that can indicate underlying skepticism about growth, even as inflation expectations rise:

  • Real rates are falling. The 10-year Treasury “real” interest rate (yield minus rate of inflation), a growth indicator, has fallen from 0.23% in late October to 0.07% at the start of 2019. That suggests government bond investors don’t see much underlying growth in the economy. Furthermore, the Treasury futures market has priced in another Fed rate cut, signaling expectations that more fiscal stimulus may be needed.
  • Defensive investments are leading markets. This includes large-cap growth stocks, as well as gold and other real assets. Indeed, one key index of commodity prices has risen 12% since the end of the third quarter.
  • Cyclicals aren’t gaining. Economically sensitive sectors, including industrials and energy, which would normally benefit in a reflationary scenario, have lagged behind gains in the broader market index lately.

These market anomalies may just be distortions created by excess liquidity in markets from recent global central bank easing. More positive signs include a steepening yield curve and rising financial stocks, powered by the climb in nominal rates. We’re also seeing strong U.S. consumer and solid housing gains.

However, investors need to avoid complacency and consider positioning their portfolios defensively, in case growth slows while inflation continues to rise. Look for companies with pricing power or the ability to benefit from higher commodity prices, such as oil producers. I also suggest adding some real assets, such as real estate investment trusts or commodities, as a hedge in 2019.