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The biggest threat to investors in 2018 – the return of inflation

Many investors’ fear a repeat of the 2008 financial crisis. But the biggest threat to your portfolio is the return of inflation. John Stepek explains the damage it would do.

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If you asked the average investor what "big picture" event they fear most right now, then I suspect the answer would be some sort of variation on "a repeat of 2008".

The financial crisis and banking collapse remains clear in everyone's minds. Subconsciously at least, the fallout from that is still driving investment allocation decisions across the globe.

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Yet the biggest threat to investors' portfolios right now is not a deflationary depression.

It's plain old inflation...

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Investors as usual expect tomorrow to be the same as today

As Ben Inker of US asset manager GMO puts it in the group's latest quarterly letter: "A significant inflation shock would be just about the worst thing that could happen to today's investment portfolios."

It's all to do with where valuations are. A depression a big downturn accompanied by deflation would be very bad for equities. But it would be good for high quality bonds, as Inker notes.

On the other hand, "inflation is very bad for high quality bonds and modestly bad for stocks." And because both bonds and stocks are highly valued at the moment, you'd get a double whammy both asset classes would be hit hard.

In effect, today's market is currently pricing in a slightly twisted parallel universe version of the "Great Moderation" economy that everyone believed had been achieved under Alan Greenspan as Federal Reserve governor.

Under the Great Moderation, inflation had been conquered, recessions defeated, and the internet would boost productivity rapidly.

Under today's bleaker version, investors don't see growth doing anything very impressive (it's not a particularly optimistic view of the future), but they do have faith in central bankers' ability to prevent growth from crashing to below zero for long. So you have an economy that will wobble along glumly, being defibrillated by central banks every time it threatens to crash again.

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As Inker argues, investors aren't hugely enthusiastic about any given asset, which I think is fair to say there are plenty of bubbly-looking areas, but nailing it down to a specific theme like "tech" or "real estate" is much harder. There are no big bets on rampant growth.

However, everyone feels that they have to be invested. They can't sit in cash. As a consequence, "sensible" assets the ones that should really lag the wider market because they are on the defensive side of the spectrum are rising in value at the same rate as the wider market. This is what's known as the "low-vol" (low volatility) trade.

Put simply, investors are heavily invested (as always happens) in the idea that today's environment will continue for the foreseeable future. It's a low-growth, low interest rate world, and assets are priced for that to carry on.

Yet with everyone focusing on the deflationary downside, they're failing to see the potential inflationary upside.

What kind of damage could inflation do?

Inker takes a look at what inflation might do to a traditional 60/40 portfolio of stocks and bonds from here.

Inker's case rests on interest rates rising to 2% "real" in other words, you should be able to get about 2% above inflation in a bank account or "safe" government bond. Prior to the financial crisis, this was once deemed normal.

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If that happened, GMO reckon that the S&P 500 would have to fall in half (roughly speaking) from today's levels. Because on the one hand, the cost of debt would rise, putting a dent in profits. And on the other, if you could get a 2% return on cash savings, you'll demand a much higher return on equities. Which in turn means that prices have to fall in order for expected returns to rise.

As for the impact on bonds to get back to levels where bonds are yielding an average of 7% (the average yield for the entire 1990s), then a bond portfolio would be "expected to lose around 25%."

In other words, if you get an inflation problem, the "sensible" 60/40 bond portfolio would shed about 40% of its value and that's just to get to fair value.

Is such a scenario likely to occur?

The main argument I can see for it right now is that it's precisely the outcome that would hurt the most investors, and history shows us that this tends to be the way that the market operates.

But getting beyond knee-jerk contrarianism, the most obvious trigger for rising inflation would be rising wages. As Inker points out, the relationship between unemployment falling and wages rising has been much more subdued ever since the financial crisis. So maybe something has changed.

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Yet, "2008 wasn't that long ago. Maybe the current situation is temporary and we will go back to the old rules. And maybe the Fed will be slow to catch on to the shift and wind up behind the curve, allowing inflation expectations to rise significantly."

In other words, the risk is that falling unemployment will indeed trigger rising wages. The Fed conditioned by years of caution paying off won't act until inflation expectations are out of hand. At that point, it'll have to hike rates harder and faster than anyone would expect.

For now, it's hard to see the precise path to that happening. The main thing is to be aware of it as one of the nastier risks out there right now.

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