"A year ago, the US economy seemed poised for a significant shift," says Ben Inker, chief investment officer at US asset manager GMO. With inflation hovering around the Federal Reserve's target level, and unemployment sitting at most experts' estimates of full employment, the US central bank "was promising to, if not take away the punchbowl, at least begin diluting the alcohol content". As a result, it looked as though we would finally get some idea of "whether interest rates would ever be able to go back to the levels that we all used to think of as normal".
As it turned out, 2017 didn't play out that way. Inflation remained subdued despite continued falls in unemployment. As a result, investors have been left "with continued uncertainty about interest rates". And, says Inker, "absent the excitement over the Faang stocks, this seems to be about the least enthusiastic bull market in history".
However, it's clear "that a significant inflation shock would be just about the worst thing that could happen to today's investment portfolios". While "depressions are bad for risk assets and good for high-quality bonds, inflation is very bad for high-quality bonds and modestly bad for stocks". And right now, "not only would bonds do particularly badly given their very low real yields, but stocks could get hit worse than you'd otherwise expect given their high valuations". Indeed, "the combination of bonds and cash suddenly yielding quite a bit in both nominal and real [after-inflation] terms seems likely to be utterly devastating to today's high valuations".
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An inflation surge certainly isn't inevitable. But "it is something that investors should have in the forefront of their minds when they think about what could go wrong".
