Does Donald Trump’s election victory mean that US investors should brace for higher inflation? Financial markets certainly think so. It may be time for investors to take note.
Of course, conditions were ripe for higher inflation even before the US election. In some developed economies, inflation potential has been building for a while. But financial markets have taken their time pricing it in.
That changed after Trump’s election on November 8. Inflation expectations have since surged, and it’s not just one indicator pointing the way. Market-based measures of inflation compensation clearly indicate that investors expect prices to rise. Meanwhile, stock markets and the dollar have rallied while global bond markets have been under steady pressure—longer-term US Treasury yields spiked by nearly 40 basis points in the week after the election.
THREE THINGS THAT COULD DRIVE TRUMPFLATION
Of course, what Trump will do as president isn’t certain. But if his core policy proposals were to become law—and with Republicans in control of Congress, there’s a decent chance some will—we’d expect inflation to rise. Here are three ways Trump’s policies could heat up prices:
HUGE INFRASTRUCTURE SPENDING, LOWER TAXES, SIMPLER REGULATION: This mix would stimulate real economic growth. But it would also stimulate higher prices, swell the deficit and drive interest rates higher.
CLAMPING DOWN ON FREE TRADE: Tearing up existing trade agreements, as Trump vowed to do during the campaign, would raise trade barriers and tariffs that would likely lead to an increase in the price of imported goods.
HITTING THE BRAKES ON IMMIGRATION: Any limits on the flow of immigrants would slow growth and create bottlenecks in an already tight labor market. Tighter labor conditions put upward pressure on wages, a key inflation driver.
All three of the factors listed above are likely to be inflationary, but only the first would be bullish for economic growth. The other two factors could actually slow growth, and a mix of higher inflation and slower growth would likely cause companies’ costs to grow more quickly than revenues, squeezing profit margins (Display 1).
Since there’s potential for one or more of these factors to come into play, investors who don’t already own inflation-sensitive assets might want to consider adding them.
TOO MUCH CONCENTRATION WITHIN INFLATION-SENSITIVE ASSETS?
But how they add these assets can make a big difference—betting too heavily on any one asset can lead to trouble. For example, many investors reacted to Trump’s surprise win by pouring money into Treasury Inflation-Protected Securities (TIPS). On the surface, this seemed logical. After all, TIPS are indexed to inflation, so their face value rises as inflation does. In other words, more inflation means a bigger bond.