A New World of Reflation
Contributed by Lewis J. Walker, CFP®
Prior to the presidential election on November 8, 2016, many economic commentators predicted a stock market rout if Donald Trump won. As election night results pointed to a Trump upset, Dow futures plunged. Observing sinking futures, at 12:42 a.m. on 11/9/16, Dr. Paul Krugman, New York Times economic columnist, winner of the Nobel Prize in economic sciences, posted, “If the question is when markets will recover, a first-pass answer is never.”
“Never” always is a bit fatalistic. Dictionary.com posits, “Nothing is impossible, anything can happen, as in Mary said Tom would never call her again, but I told her, ‘Never say never.’ This expression was first recorded in Charles Dickens's Pickwick Papers (1837).” Since Krugman’s dour call, in the post-election referendum, investors voted by pushing key stock indexes to new highs!
Aeschylus (523-456 B.C.) was a Greek playwright, dubbed “the father of tragedy.” As to pondering one’s future, he flatly advised, “The future you shall know when it has come; before then, forget it.” Nevertheless, we continue to channel 21st century oracles to get some sense of where economics and investments may be headed. Prudence says, don’t bet heavily on one opinion, which is why we diversify in sync with our personal risk tolerance. But there are broad trends unfolding worth considering. One is reflation, the opposite of deflation.
Investopedia defines “reflation” as “fiscal or monetary policy, designed to expand a country's output and curb the effects of deflation. Reflation policies can include reducing taxes, changing the money supply and lowering interest rates.” Reflation often signals early economic recovery after a period of contraction.” The 2008 Lehman Brothers banking collapse precipitated a global crisis and market debacle that unleashed massive monetary policy actions by governments and central banks, driving interest rates to rock bottom lows, with subdued inflation. BlackRock Investment Institute strategists see “fiscal expansion gradually replacing monetary policy as an economic and market driver around the world.”
We emphasize “around the world” as international stocks have lagged U.S. domestic equities for some time. It took foreign central banks longer to respond to the 2008 crisis, and the MSCI World Value Index has seen the longest period of underperformance since 1980. Value underperformance versus long-term trends led to significant outflows of funds and a growing valuation spread between value and growth stocks. That trend seems to be reversing, especially as some “hot” stocks get a bit pricy. International and global equity managers are seeing inflows of capital.
BlackRock believes global bond yields have bottomed. This trend would seem to favor equities over fixed income. Nevertheless bond strategies still have implications for investors who want to limit risk exposure in equities. In our view this favors separately managed bond accounts with laddering strategies over blindly throwing money into bond mutual funds that have track records built when interest rates were declining. Rising interest rates are a whole different animal. Credits, syndicated loans and paper with variable interest rates tied to an index like LIBOR are favored over fixed rate government bonds.
Rising inflation is broad-based, especially in America, notes BlackRock. Per The Wall Street Journal, the All Items U.S. Consumer Price Index is up by 2.50% trailing one year through January 2017. In our retirement planning calculations, we inflate expenses by 3.00% annually. At some point that may be a low estimate.
“The future” is where you will spend your money, whether to fund educations, buy a new home or car, take a bucket list trip, expand a business, or generate retirement cash flow. At a 20% average (not marginal) income tax rate and 3% annualized inflation, the breakeven return after taxes and inflation is 3.75%. At that rate you merely are treading water. Shopping may get you 1.05% on a FDIC-guaranteed money market fund or 1.80% on a 3-year CD, but you see the challenge. You are losing future buying power after taxes and inflation. Real growth of capital takes risk. Always has. Defining “prudent risk” is integral to the planning process.
A tighter American labor market will push up wages. While adding to increasing prices for goods and services, jobs and rising wages are good for investor confidence and consumer spending. The U.S. Federal Reserve is likely to be more aggressive in raising interest rates; good for savers, bad for borrowers and the overly leveraged. BlackRock notes, “The prices of more than half the goods in the U.S. CPI basket are rising at an above-average historical pace for the first time since 2008.” When winter sets in, we check the weatherproofing on our house. How’s the “inflation-proofing” on your financial house?
Reflation. A new word in the planning lexicon. What does that mean to you?
Lewis Walker is a financial planning and investment strategist at Capital Insight Group; 770-441-2603. Securities and advisory services offered through The Strategic Financial Alliance, Inc. (SFA). Lewis Walker is a registered representative and investment adviser representative of SFA which is otherwise unaffiliated with Capital Insight Group. Past performance is not a guarantee of future financial results.