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How Investors Can Profit From This Return Of Inflation

By Stephen McBride | Articles | February 16, 2017

Secular stagnation may have kicked-off 2016, but 2017 has started with a reflationary revival. In January, the consumer price index (CPI) recorded 2.5% year-over-year (YoY) growth - Its highest reading since early-2012.

Inflation has been trending upward since 2015, but it’s ascent has only come to the forefront since the election.

Although the current inflation rate is low in a historical context, its return has widespread implications.

Many Happy Returns

Growing inflation has caused bond yields to rise. The 10-year Treasury yield, which moves inversely to its price, is up 45% since July.

The bout of reflation has given equities a boost. From 1973–2016, equities performed best when inflation was running between 1–3%. Since July, the S&P 500 and the Dow Jones Industrial Average (DJIA) are up 6.5% and 8.6%, respectively.

Wage growth, long missing in the post-crisis recovery, is back. Average hourly wages were up 2.5% YoY in January. Rising incomes are possibly the most important aspect of this reflationary move. The self-reinforcing dynamic of higher earnings feeds inflation and helps consumer demand.

An increase in labor costs could weigh on corporate profits. However, with margins near all-time highs, companies have the ability to absorb greater input costs. In the last 3 periods of reflation, corporate profits and salaries have moved higher in tandem.

This uptick in inflation looks to be positive for economic growth. However, inflation’s comeback has some downside.

Two Sides to the Story

The headline 2.5% CPI number doesn’t tell the full inflation story.

In January, healthcare costs rose 4.7%, rents were up 3.5%, and energy jumped 10.9%—all YoY. While prices fell for discretionary items like cars, the cost of basic necessities rose substantially. Dr. Pippa Malmgren has called this phenomenon “bi-flation.”

This is negative for growth because it stunts consumer spending. For 80% of US households, rent, energy, healthcare, and food comprise 80–90% of their total expenditures.

Given that consumers account for 70% of US economic activity, strong demand will be crucial to future growth. As the Federal Reserve has stated, expansions don’t die of old age—a sharp drop in demand often leads to their death.

Although the 2.5% CPI figure may distort the full picture, it does have important implications. While the current inflation rate is still below historic norms, investors must adjust their expected returns based on its climb. Earning 2% returns over the last few years would have kept you above water. Those days are gone.

Creeping inflation is a greater concern for the non-investor. Your money must be put to work, or your wealth will be eroded in real terms. To be clear, I am not stating that inflation is out of control, which is clearly not the case. I am saying that inflation above 2% has consequences that require a recalibration of strategies.

So, how can we protect ourselves and profit from a new inflation climate?

Strategy Required

As stated above, equities have performed well in periods of mild inflation. Inflation is not likely to hit 3% due to headwinds like a strong dollar and slow global growth. So, stocks could be a good bet.

Focusing on cyclical sectors like financials and materials seems wise. These sectors benefit most from inflation as they earn higher revenues during economic expansions. If labor costs climb, sectors with high margins should be least impacted. Financial services companies and banks have some of the highest margins across all industries.

Use caution when investing in dividend stocks. The average dividend yield on the S&P 500 and DJIA is 2.38% and 2.75%, respectively. If inflation is running a little over 2%, it cuts deep into these yields.

A new asset class that investors should also pay attention to is Peer-to-Peer (P2P) Lending. The P2P sector has grown rapidly in recent years and is generating market beating returns. In 2016, P2P investors earned net annualized returns north of 7%.

Even those who took the most conservative approach saw returns of 5%. That’s more than double the average S&P 500 yield. If you want to learn how to get started, you can download our free report, Welcome to the Bank of You.

Investors can gain upside from inflation through Treasury Inflation Protected Securities (TIPS). In 2016, TIPS returned 4.7%, while Treasuries returned a measly 1%. TIPS funds have now seen seven straight weeks of net inflows.

Commodities have historically performed well during periods of inflation. Following a dismal end to 2016, gold is up 7.5% since the start of this year.

In closing, this upswing in inflation is good for economic growth, but it does have some downside. If inflation continues to tick higher, you will need to earn better returns on your capital to grow your wealth.

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