The New, New, New Normal – Low Inflation

This week, the Federal Open Market Committee (FOMC) released its July meeting notes. The notes show a discussion of softness in inflation in recent months. Many participants saw some likelihood that inflation might remain below 2% for longer than currently expected, and several indicated the risks to the inflation outlook could be tilted to the downside.

Low inflation in an economy with full employment, rising wages and rising home and stock values seems odd.

In the second half of the 1990s, inflation declined from about 3.5% to a range of about 1% to 2%.

Does twenty years of low inflation since 1997 make a trend? It might. The technology boom accelerated sharply in the late 1990s with the rapid advancement of broadband Internet, smart phones, PCs/tablets and adding digital intelligence to almost everything. The cost of doing business declined and price transparency increased. Global competition increased and automation replaced many workers. Technology development has been deflationary.

Low inflation is a positive for stocks. If inflation remains low (below 2%), interest rates are likely to remain low. Low interest rates stimulate investment (including in stocks, homes and by businesses in new projects). For the eight years following the 1933 depression market low, average annual inflation was 1.58% and the S&P 500 increased by about 50%. For the eight years following 2008, annual average inflation has been 1.38% and the market is up over 160%.

In the bigger picture, inflation was low from 1933 up until 1965 with the exception of the WW2 years and a couple of years following. During this low inflation period, the stock market advanced by about 785%. During the bull markets of the 1980s and 1990s, inflation was about 3.25%.

Conversely, high inflation is generally negative for stock valuations. From 1965 to 1982, the average annual inflation rate was almost 7%. The S&P 500 had an average annual return of roughly 1.4% per year during those 17 years.

The new, new, new normal which we may be awakening to is the idea that inflation will remain low for years to come as technology advancement and globalization are enduring trends. Many investors began 2017 with high conviction that the 10-year treasury rate would end the year at about 3%. Year-to-date, it has traded down from about 2.6% to about 2.2%. The low inflation trend remains in place despite the extraordinary measures of the Fed to raise the inflation rate and the growth of the economy. Additionally, the Fed is indicating that it intends to shrink its balance sheet (sell bonds) in the fourth quarter which was expected to cause rates to rise in anticipation (markets are usually forward looking).

As investor sentiment migrates increasingly to a belief that inflation and interest rates will remain low for years, asset prices should get a boost. During a CNBC interview in May, Warren Buffett said, “The most important item, over time, in valuation is interest rates. It’s a huge bargain to buy stocks now if you knew interest rates would stay at this level.” He added, “Anybody that prefers bonds to stocks is making a big mistake.”

In May of 2017, the S&P 500 was roughly 2,400. Today, it is roughly 2,450. This week, the Leading Economic Index (LEI) for July was reported at 0.3%. This is the eleventh consecutive positive month-over-month percent change. We remain bullish.

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Jeffrey Sweeney