The Two Questions You Need to Ask

Investors were avoiding two key questions, but now they’re paying attention.

It was easy to overlook these questions for more than a year, because we were in the sweet spot of the business and market cycles. Yet, that’s the time when it’s most important to probe these questions, and
we’ve been doing that.

Since mid-2016, I’ve emphasized three likely developments: sustainable global growth, higher inflation and rising interest rates. This was a minority view, but the developments now are established trends.

I developed these ideas by asking the two questions. How is the future likely to be different from the recent past? What is already priced into the markets? After all, there’s no benefit to being right about the future if it’s already widely expected and priced into the markets.

Here’s how I’ve been answering these questions and still answer them today.

For the next six to 12 months, economic growth again is likely to be stronger than expected. Thanks to tax cuts, deregulation and other factors, growth surged above expectations in the latter part of 2017. There is strength in household spending, housing and industrial production and other business activity indicators.

The potential growth is higher internationally than in the United States, because America is further along in the economic cycle and is closer to its peak. While investors are noticing higher returns, and shifting parts of their portfolios overseas, stock prices in foreign countries still have increased only in line with recent earnings growth.

I also expect inflation to be higher than has been priced into the markets.

The Fed has had trouble pushing inflation to its 2% target, triggering complacency among investors. But
inflation is close to 2% in the United States. Several factors that had kept a lid on inflation are fading.
Investors finally started to realize this in late January and early February, triggering the sharp declines in the stock indexes. But it’s likely markets still are underestimating inflation.

Normally, when unemployment is this low, inflation is high and rising because employers offer significant pay increases to attract and retain workers. The overhang from the financial crisis delayed that effect in this cycle.

Now, there isn’t much slack in the labor market. Average wage gains increased fairly steadily the last couple of years, and employers say they anticipate paying higher wages and salaries in the next year. Automation and global competition will restrain wages some, but the lack of available workers
should push wages higher.

Temporary factors restrained price increases in cellular telephones, medical care and education in 2017. But those factors are winding down. Also, commodity prices are rising. No longer are falling commodity prices offsetting rising prices for services.

While deflationary forces from the pre-2007 boom and the financial crisis help offset some inflationary pressures, the deflationary pressures are in the background for a while.

Each year since the financial crisis, the Federal Reserve and other central banks increased interest rates
less than expected. Market pricing indicates for the next two years that investors again expect rates will rise less than the Fed forecasts.

If I’m right about inflation and growth, the Fed will raise short-term interest rates more than the markets anticipate. Also, the markets will continue raising intermediate- and long-term interest rates.

Higher-than-expected interest rates, of course, will be negative for bonds. That’s why we scaled back our traditional bonds some time ago. It is possible rates will rise so far that growth will be reduced, while prices of stocks and commodities will decline.

But that will come later. I’m not urging you to sell today. We identified today’s trends early and  momentum has been going our way. We’ll continue to wait for signs that it’s time to change.