In our last update we discussed some of the surprising returns logged by various asset classes so far this year and detailed what it will take for the positive results to continue.  Today I want to focus on a topic that had been on investors’ minds a few years ago but gradually fell out of the spotlight: Inflation.

With the economic data through the end of June continuing to suggest a consistent recovery from the harsh winter and the abrupt slowdown in U.S. growth (final Q1 GDP was recorded at -2.9%), the pace of inflation is beginning to accelerate.  Specifically, the “headline” consumer price index began the year moving at a rate of 1.4%.  Six months into 2014, the rate has reached 2.1%.  Stripping out volatile food and energy prices, the so-called “core” inflation rate has also shown steady acceleration — moving from 1.1% to start the year to 1.9% as of June.  We recognize that there are weaknesses in the present methodology used to calculate CPI but other inflationary indicators such as unit labor costs, the personal consumption expenditure deflator and the producer price index also show acceleration.  Moreover, there are more frequent reports about labor shortages in certain base manufacturing jobs such as welding.

Inflation is an interesting economic / monetary phenomenon.  The goal of any central banker is to get it “just right” – not too hot, not too cold – however achieving this outcome is challenging because many uncontrollable factors are involved.

Since the U.S. Federal Reserve initiated its quantitative easing policy (QE) several years ago, one of their stated goals was higher inflation.  Hoping to avoid the two-decade-long bout with deflation that Japan has suffered, the goal was to bring price escalation gradually back into play while attempting to avoid 1970’s style stagflation wherein prices continue to rise but no growth or job creation exists.  What makes this very tricky is getting the preferred type of inflation, demand-pull, without igniting the more harmful cost-push variety.  In a very basic sense the difference lies in the main catalyst for the inflationary acceleration.  In the demand-pull variety, consumers and businesses are spending more aggressively – catching suppliers and producers off-guard and temporarily providing them pricing power.  The more harmful cost-push variety means input costs are going up with no measurable uptick in end demand.

As the second half of 2014 opens, inflation is poised to be a bigger topic in the financial markets.  As stated earlier some inflation is preferred but the type of inflation and the ability to contain it will be a more significant driver for which asset class performs best.  Bond investors who decided to extend the duration or average maturity of the bonds they purchased in hopes of generating higher yield may be vulnerable to a sudden sell-off as investors reassess the real return they are earning.  Other vulnerable investors would  include those who bought bonds on the belief US growth was slowing leading to disinflationary pressures.   Similarly, should the Federal Reserve suddenly be forced to increase short-term benchmark interest rates to cool things off, global stock markets could come under pressure.  On the other hand demand-pull type inflation may be supportive to the stock markets as a clear sign more revenue growth is on the way.  Unfortunately for bond investors anything that makes stocks more appealing is not welcome news.

The bottom line is that long-dormant inflation may be showing signs of life In the U.S.  This is not good news for yield-chasing bond investors regardless of the type of inflation that is potentially on the way.  However for stock investors the type of inflation is very important.  Demand-pull could be good for revenue and earnings, while cost-push could cut margins and stunt growth.

It is too early in the trend change to properly analyze what is behind the uptick in U.S. inflation but from this point forward it will be increasingly important to take it into account when determining how to invest capital.

We’ll keep you posted as more data becomes available.

Jack E. Payne, CFA, CFP®

Chief Investment Officer