Video: Investment Considerations for Today’s Low Inflation Environment

Investment Considerations for Today’s Low Inflation Environment

RECORDED APRIL 20, 2019

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Ann Hynek: A strong U.S. labor market has led to an acceleration in wage growth. Good news though it may be for workers, there are other implications associated with this trend. However, as Lord Abbett's Giulio Martini explains, inflation isn't necessarily a given. This is the Investment Conversation.

VISUAL: Ann on camera

Hi, I'm Ann Hynek, here with Lord Abbett's director of strategic asset allocation, Giulio Martini. Welcome, Giulio.

VISUAL: Giulio on camera

Giulio Martini: Hi, Ann. It's a pleasure to be here.

VISUAL: Ann on camera

Ann Hynek: So, the last time we spoke, we talked about-- acceleration in wage growth as well as the implications for Fed policy and inflation. We talked about the standard of living-- continuing to improve and what that means essentially for investors and whether or not this trend can last. Can you elaborate a little bit on that?

VISUAL: Giulio on camera

Giulio Martini: The process usually starts-- with workers who are willing to change jobs to get higher pay.

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And those tend to be younger workers at the lower end of the pay scale.

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The next step is really when wages start to go up for workers in their current jobs. And those tend-- those incumbent workers tend to be older workers at the higher end of the pay scale. And when you start to see wage increases spreading broadly across

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the spectrum of older, younger workers, higher and lower paid workers, that's when you really have a generalized acceleration in labor costs.

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And that's what we're seeing. There are a variety of different indicators which all point in that direction.

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Ann Hynek: But Giulio, does rising wage growth then mean rising inflation?

VISUAL: Giulio on camera

Giuilio Martini: Well, Ann, not necessarily because employers don't just sit still as labor costs start to increase.

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We really live in a world of Amazonification (PH), I would call it, where consumers have access to information about prices across a broad range of potential suppliers.

And they can always find the lowest price offer very easily and very cheaply.

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And so employers really have a hard time passing labor cost increases on. And the way they try to offset that is by getting more out of each worker even as they pay people more.

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And what that amounts to is a dynamic of rising productivity.

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And that's what we're seeing over the past year, year and a half, is that as labor costs have increased and as they've increased more rapidly, productivity has also picked up. And so the unit costs of production are not necessarily going up along with rising wages. And as a result, employers can maintain margins, profitability, and pass—

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and have higher wage costs without necessarily needing to raise their prices.

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Ann Hynek: So what then does low inflation mean for investors?

VISUAL: Giulio on camera

Giulio Martini: Well, it's really something that is very positive for investors because rising inflation tends to force interest rates higher. And higher interest rates mean that the value of

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future earnings, future dividends, future coupon payments for bond holders are just worth less today.

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So when inflation starts to accelerate and interest rates rise, financial asset prices adjust downwards typically.

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Ann Hynek: So Giulio, tell us-- what does it mean for stock and bond investors if, one, interest rates start to go up, and two, people start to think that the cycle is coming to an end?

VISUAL: Giulio on camera

Giulio Martini: Well, those things typically go hand in hand, rising interest rates and increasing fears about the end of the cycle, but the dynamic has really, really changed from-- the world before the early 1980s and the world after the 1980s.

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What we tended to see before the 1980s is a cycle whereas the labor market tightened,

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wage costs and benefit costs would increase rapidly enough to push unit production costs higher at a significant pace. That was an era when labor had more bargaining power,

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when labor union bargaining really led the way in terms of wage increases for workers who were not unionized.

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And we tended to see just a much more rapid acceleration in wages at the end of the cycle. That forced interest rates up and eventually caused a peak in the economy and the next recession to begin as monetary policy tightened enough to create that downturn.

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What we've seen since the early 1980s, and now it's been across, you know,

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three major business expansions, is that wage costs have not picked up as rapidly. And as a result, productivity has been enough to really contain the rise in wage costs and prevent inflation from accelerating very much-- if at all really towards the end of the cycle. And that's been great for investors because what it's meant is that strong stock returns have maintained themselves deeper into economic expansions than they had before.

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Now that all comes undone if inflation starts to rise. That's really the thing we need to keep our eye on.

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Ann Hynek: So Giulio, we've talked before about globalization and trade. In fact, in one of the episodes of the Investment Conversation, you spoke a lot about China. So if globalization and trade were to slow down a little bit, what would that mean for inflation as well as for investors?

VISUAL: Giulio on Camera

Giulio Martini: So if we look at import penetration in the U.S. economy, for instance, how much of U.S. consumer spending on goods-- comes from imports, that ratio kind of leveled off about ten years ago. So globalization is very much front and center in our minds, but as a process, globalization is really in a pause right now.

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Now, the benefits of globalization are that it increases the economy's sources of supply. Typically firms go overseas to access lower cost labor by building global supply chains that they can then bring-- goods back to the U.S. economy at lower cost.

VISUAL: Giulio on Camera

And that, of course, as its increasing, is helping to keep inflation low. That's the benefit, is lower priced goods and increased competition on domestic suppliers of those goods, which also forces them to hold their prices low.

What we're seeing now-- and-- and if you look a long-term chart of the relationship between the prices and goods and the prices of services, which tend to be domestically produced, goods prices have been falling very, very steadily for the past 50 years.

And that's-- one-- as I said before, that's one of the main factors that in-- that have kept inflation low. What we're starting to see is a little bit of a break in that trend as globalization has really peaked and stopped increasing. And that suggests that we could start to get less of a benefit from low inflation and goods prices going forward than we've had on average for the past, you know, multiple decades.

If that's true, and especially if the-- situation is aggravated by trade tensions or by increasing tariffs, then something that's been a tremendous benefit in keeping inflation low could be much less of a benefit going forward or even a factor in aggravating inflation and pushing it higher suddenly. And that's certainly one of the things that we need to watch out for because once inflation gets going, it tends to feed on itself if it causes people to start anticipating higher price increases.

VISUAL: Ann on camera

Ann Hynek: Giulio, how should investors be thinking about inflation and ultimately what that means for their portfolios?

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Giulio Martini: We are ten years into a period of economic expansion and inflation hasn't started picking up.

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And there aren't really any clear signs that it's going to anytime soon. But inflation is really the fundamental risk factor that we have to keep an eye on,

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so there will at some point be upward pressure on inflation.

VISUAL: Giulio on camera

The labor market-- will tighten to a point where wage increases and benefit increases are high enough that firms can't keep up by increasing productivity. And at that point we're gonna see more pass through from wage costs into inflation.

And also at some point the economy will just grow rapidly enough so that demand adds to cost pressure to push inflation higher. And at that point, I think what we have to expect is that the Fed will start to be very vigilant and push interest rates up to prevent inflation from becoming a chronic problem.

And that's when investors and markets in general will start to associate more growth with higher inflations and more monetary tightening and the end of the cycle. And the problem with that is that as inflation and interest rates go up and create losses for bond holders, the anticipation of the end of a period of economic growth will cause stockholders to mark prices down again.

And what we could see reemerge is the kind of positive correlation between stock and bond returns that's been really bad for investors in the past. Because when stock and bond returns are positively correlated, it means the diversification in your portfolio is much less than it would be if that correlation were zero or negative.

And at that point, there's a broad need to start to de-risk portfolios. And so that's what I think investors have to watch out for is the start of the process of rising inflation, the reaction from the Fed that really triggers monetary tightening, and the anticipation of the end of the cycle because that's gonna be-- a point in time where reducing risk in portfolios is really warranted.

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Ann Hynek: Thanks, Giulio. So to recap, wages continue to increase, inflation isn't a concern at this time, but that doesn't mean it won't become one. We will continue to monitor Central Bank policy, trade tensions, and tariffs, plus the implications for inflation. Be sure to tune in next time to the Investment Conversation.

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Glossary:

The business cycle refers to the increase and decrease in the production of goods and services in an economy.

The U.S. Federal Reserve (Fed): The central banking system of the United States

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