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Higher Inflation Is Low-Key Threat

by Community Manager

‎09-03-2014 12:17 PM

market commentaryBy Arne Espe, vice president of mutual fund portfolios

 

The world’s central banks want more inflation. They should be careful what they wish for.

 

There’s not much talk about inflation these days. In fact, the chief worry is in the other direction — toward deflation. The eurozone is teetering on the brink of a triple-dip recession, with some of its largest member nations perhaps already over the edge. In Asia, Japan’s effort to defeat deflation has been a fruitless work in progress for more than two decades now. Here in the U.S., where the economy is slowly emerging from a balance-sheet recession triggered by too much corporate and household debt, inflation has been below the official annual target increase of 2% since early 2012.

 

But in recent months, as the economy has gained strength, inflation has been approaching that 2% target. This is concerning many investors, who lately have been buying more inflation-protected Treasuries. Also concerned is the Federal Reserve, which may accelerate its timetable for raising short-term interest rates to try to head off above-target inflation. But with many trillions of stimulative, Fed-minted dollars flowing throughout the economy, holding back inflation could be a tough task indeed.

 

This is not to say that 1970s-style inflation is hiding just around the next corner or the next quarter. But just as we advise our members to take a long-term perspective when it comes to their investments, so too should they be mindful of the long-term economic threat posed by inflation.

 

This week, the European Central Bank, increasingly worried about stagnant growth in the eurozone, may announce plans for some sort of a quantitative easing program to try to inject some liquidity and some life into its economy. This approach may make short-term sense, given the dire consequences of deflation seen in Japan. But over the longer term, adding more money to the European financial system raises the global inflationary risk. If the ECB follows this course, it will eventually find itself in the same precarious position as the Fed — attempting to draw down the excess liquidity before it becomes dangerous.

 

I may be a little more extreme than most of my USAA colleagues on this subject, but to my mind, inflation is the single biggest risk investors face over the next decade. And we’re seeing signs that it may be rising.

 

The Fed’s monetary stimulus and its near-zero peg for short-term interest rates has led to price inflation in financial assets, which lowers their expected future rate of return. As a measure of equity price inflation, the Standard & Poor’s 500 index has hit 32 all-time highs in 2014 during a period of tepid economic growth. In addition, the cost of housing, particularly for renters, is rising much faster than overall prices as measured by the Consumer Price Index, and those cost increases are expected to accelerate in the near term.

 

Significant price increases in equities and housing have historically been leading indicators of inflation. Credit growth, which we have also seen as lending picks up, is another leading indicator, as is the price of gold. Gold may be well down from its 2011 peak price, but it is still more than 50% above where it was at the start of the financial crisis, when the government began cranking up the available money supply. The rise in retail prices that we as consumers typically associate with inflation is actually a lagging indicator. The runaway prices that we saw in the 1970s, for example, were incubated in the high-growth 1950s and ’60s.

 

One final thought: In a stable money system, we should see lower prices as production and distribution become more globalized and more efficient. We’ve seen steadily lower technology prices, but that’s not been the case across other sectors. Given this expectation of lower prices, the annual increase of 2% or so in the Consumer Price Index is yet another indicator that inflationary pressures may be strengthening.

 

USAA Investments Managed Portfolio Outlook

Our view of caution toward U.S. equities remains unchanged — we are underweight U.S. large caps and small caps. While signs point to continued recovery of the U.S. economy, valuations are no longer cheap, and profit margins are near record highs.

 

We are tactically underweight fixed income, primarily to fund a deployable cash position. Within fixed income, we prefer areas of the market that are more credit-sensitive and less sensitive to changes in interest rates, such as investment-grade corporate bonds and high-yield bonds. The USAA Intermediate-Term Bond Fund and the USAA High Income Fund fit this profile.

 

We are overweight to assets that are positively correlated to inflation expectations. The USAA Real Return Fund provides potential protection against the risks of long-term inflation.

 

We are overweight non-U.S. developed markets and emerging markets based on relative valuations. Though they have been hit especially hard recently, we believe that emerging markets remain attractive. Along with compelling valuations, they offer an interesting long-term prospect for growth. The USAA Emerging Markets Fund offers exposure to stocks in less-developed countries.

 

As always, we encourage investors to speak with one of our financial advisors, who can help determine which investment vehicles are best suited for your individual goals, objectives, risk tolerance and time horizon.

 

Consider the investment objectives, risks, charges and expenses of the USAA mutual funds carefully before investing. Download a prospectus containing this and other information about the funds from USAA Investment Management Company, Distributor. Read it carefully before investing.

 

Past performance is no guarantee of future trading results. Diversification does not guarantee a profit or prevent a loss.

 

This material is for informational purposes and is not investment advice, an indicator of future performance, a solicitation, an offer to buy or sell, or a recommendation for any security. It should not be used as a primary basis for making investment decisions. Consider your own financial circumstances and goals carefully before investing.

 

Investing in securities products involves risk, including possible loss of principal.

 

As interest rates rise, existing bond prices fall.

 

The S&P 500 Index is a well-known stock market index that includes common stocks of 500 companies from several industrial sectors representing a significant portion of the market value of all stocks publicly traded in the United States. Most of these stocks are listed on the New York Stock Exchange.

 

Gold is a volatile asset class and is subject to additional risks, such as currency fluctuation, market liquidity, political instability and increased price volatility.  It may be more volatile than other asset classes that diversify across many industries and companies.

 

Non-investment grade securities are considered speculative and are subject to significant credit risk. They are sometimes referred to as junk bonds since they represent a greater risk of default than more creditworthy investment-grade securities.

 

Foreign investing is subject to additional risks, such as currency fluctuations, market illiquidity, and political instability. Emerging market countries are most volatile. Emerging market countries are less diverse and mature than other countries and tend to be politically less stable.

 

Investments provided by USAA Investment Management Company and USAA Financial Advisors Inc., both registered broker dealers. Financial advice provided by USAA Financial Planning Services Insurance Agency, Inc. (known as USAA Financial Insurance Agency in California, License # 0E36312), and USAA Financial Advisors, Inc., a registered broker dealer.

 

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