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Of Mutual Interest: Reacting to rising inflation and rates

Last Updated May 17, 2018 at 1:00 pm EDT

This 2011 photo provided by Russell Investments shows Steve Wood, chief market strategist for Russell Investments. Investors are fearful of runaway inflation, and they keep waiting for signs inflation is about to pick up. Most experts agree that inflation is going to speed up, and that the Federal Reserve will keep raising interest rates in order to keep inflation pressures from getting out of control. While the timing is unclear, Wood says it's not too soon to prepare. (Russell Investments via AP)

NEW YORK, N.Y. – Investors are fearfully watching for signs that inflation is picking up. Stocks tumbled in February when Wall Street thought a big increase was coming, and since then, stocks have rallied when the market received signs that inflation was in check.

Most experts agree that inflation is going to speed up eventually as the economy expands, and that the Federal Reserve will keep raising interest rates in order to keep inflation pressures from getting out of control.

While it’s not clear exactly when greater inflation will arrive, Steve Wood, chief market strategist for Russell Investments, says it’s not too soon to prepare. Also, Wood says investors need to pay attention to a global disconnect in interest rate policy.

Even as the Federal Reserve, under Chairman Jerome Powell, raises borrowing costs in the U.S. to stave off inflation, central banks in Europe and Japan are still keeping interest rates low and buying bonds in order to stimulate their own economies.

Answers have been edited for length and clarity.

Q: What trajectory do you expect for inflation?

A: The goal is to figure out where inflation is going within the context of Fed policy. The underlying data is that inflation is increasing toward the Fed’s target of 2 per cent. The improvement in inflation is going to give the Fed confidence that it can remove much of the emergency accommodation it afforded following the global financial crisis. One ignores the Fed and Fed policy at one’s own peril.

Since February, the market is beginning to process the policy positions of a Powell Fed, which is looking at an improving economy, improved labour markets, and inflation that they feel is on target. As we all know, it’s not inflation, it’s inflation expectations which are important, and the Fed wants an environment where inflation expectations are anchored at that 2 per cent range.

Q: What kind of adjustments are you making as you see signs inflation is on the rise?

A: To many the most obvious would be the impact of rising rates in fixed-income, and over a shorter time environment that’s true. In a rising rate environment, the price of fixed income assets (like bonds) drops.

There are also implications in asset classes with an equities base. Also there are implications in terms of the economic cycle. It’s global, too. (Central banks) are using similar policy tools, but they’re not using them at the same time. That creates cross currents, and from a global investors’ outlook that creates an opportunity to manage risk more robustly.

Q: How would you advise investors to respond?

A: In the U.S., we see an economic cycle which is aging, earnings are going to look excellent this year but again aging, and a Federal Reserve that has made clear that they will follow a disciplined path to pursue rate hikes and remove accommodation. It’s an opportunity for a U.S. dollar-based investor to balance into other parts of the world that are in a younger economic cycle.

We’ve been telling U.S. dollar-based investors that the last several quarters have been an opportunity for them to rebalance globally, for example in Europe. Europe has a younger economic cycle, valuations are attractive relative to the U.S., and the European Central Bank is still in an accommodative, easing policy cycle. After a very strong nine-year bull market in the U.S. equity space, they can rebalance that in a global and multi-asset portfolio.

Q: Does that mean you’re more focused on geographies rather than asset classes?

A: I think we’re looking at asset classes and geography simultaneously. If one were to look at the economic cycle of the U.S vs. the euro currency zone, one would say that the U.S. would have a much older economic cycle. A tightening central bank in the U.S. would be compared to a European Central Bank that is still providing accommodation and has rates very low.

Earnings and valuations in Europe look relatively more attractive than they would in the U.S. The risk-adjusted return picture for an investor would suggest that rebalancing from an asset class and a geography that has done quite well, where valuations are high, to areas where asset prices are relatively low and monetary policy might be a tail wind.