Preparing for a Likely Turn in the Markets, Economy

Investors are facing another surprise. This will be the opposite of the surprise many experienced in early 2016. You remember that in 2015 and as we rolled into 2016, most investors were expecting steady increases in U.S. interest rates, rising inflation and a growing economy. All of that was priced into the markets. Instead, economic growth stalled, commodity prices continued to decline, and a series of bad news from China triggered a global panic. Suddenly, everyone was concerned about deflation. Interest rates fell. Bonds and other defensive investments rose in value, while stocks sank.

Fortunately, we disagreed with the consensus forecast in 2015 and were positioned to benefit from the surprise. We profited from positions in long-term bonds, utility stocks and preferred stocks.

In early 2016, central banks quickly implemented policies to combat deflation. The Fed increased the monetary base rapidly, and then dramatically scaled down its planned rate increases for the year. Central banks in Europe and Japan announced additions to their already-expansionary monetary policies. China announced a series of policy changes designed to stop the negative trends that were in place at the start of the year.

All these actions are teeing up investors for the next surprise. Markets haven’t responded much to these changes.

Market prices generally indicate that investors expect the trends from the beginning of the year to continue. They’re expecting years of very low interest rates and inflation with modest economic growth.

Yet, the strong deflationary forces that were in place through 2015 and early 2016 have abated. Commodity prices stopped declining. Oil, for example, has almost doubled from its recent low. Inflation is inching higher in the United States and recent wage growth is at or above the average of the economic recovery. Retail sales have been rising. In the next six to 12 months, inflation could very well rise faster than markets anticipate. I’m not expecting anything like the inflation from the 1970s, but markets are pricing in long-term expectations of inflation below 2%. A small, consistent increase in reported inflation would require a repricing of assets.

Investors also could be too pessimistic about the U.S. economy. Housing has been doing well and has improved in the last few months. Housing is likely to continue to grow at recent rates and contribute to overall economic growth.

Manufacturing appears to be finding a bottom and recovering from its depression of the last 18 months or so. Manufacturing no longer is being hurt by sliding commodity prices, a rising dollar and negative growth outside of the United States.

Commodities likely reached their lows or will soon. As prices slumped, commodity producers dramatically reduced production and investment. This typically is the sign of a bottom in commodities. Since global economic growth is continuing, soon supplies of various commodities will be less than demand. Once producers are confident the bottom of this cycle is behind us, it will take a while for production to increase. So, prices will rise for a while.

The U.S. labor market is strong enough that wage increases are more steady. Some businesses report having trouble finding enough qualified workers. In some regions and sectors, businesses are raising salaries to compete for workers. Strong recent retail sales indicate households are optimistic about the future.

Global growth also seems likely to improve as the European Central Bank continues to do what it can to stimulate growth. The bottom in commodity prices is likely to help growth in emerging markets, especially in the Latin American economies. China recognized it made policy mistakes the last couple of years and has taken actions to reverse the mistakes. A more stable China should help growth in other emerging economies.

The major impediment to higher U.S. growth now is weak capital investment by businesses. In fact, investments have been declining. Though there’s no guarantee, business investment is likely to improve, because of the improvements in retail sales in the United States and growth outside the country.

I’m not expecting a global boom or rapidly rising inflation. Absent intervening events, however, the pieces are in place for growth and inflation to be higher than what’s priced into the markets. What matters to investors is the difference between what’s priced into markets and what actually happens. That possibility of higher growth and inflation than what the markets are expecting needs to be reflected in our portfolios.