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Market Perspectives February 2017

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Below please find a link to our monthly market perspective piece for February. This month, with the prospect for potential policy changes ahead, we take a deeper dive into the concept of inflation and what it means to investors.

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Market Perspectives February 2017

  1. 1. Market Perspective – February 2017 Experience Insight Impact biegelwaller.com Overview: Since the election, undercurrents of inflation have reemerged. Considering the possibility of meaningful policy shifts under the new administration, we find it important to explore various aspects of inflation – how it impacts investors (and consumers) and what expectations look like moving forward. 1
  2. 2. Experience Insight Impact What Is Inflation And Why Is It Important? • Inflation is the rate at which the general level of prices for goods and services rises. • The concept of inflation is important to understand because it erodes the purchasing power of money. • The Consumer Price Index (CPI) measures the weighted price average of a basket of consumer goods and services (i.e. transportation, food and medical care). • According to the CPI, due to inflation, a weighted basket of goods and services costs 5x more today than it did prior to the 1970s. 2 U.S. CPI Index Source: Bloomberg
  3. 3. Experience Insight Impact Long-Term Inflationary Impacts The biggest impact of inflation is its erosion of purchasing power, which has profound negative implications to holding cash. 3 Ten Year Treasury Yield
  4. 4. Experience Insight Impact The Historical Inflation Perspective on Stocks and Bonds • Due to loss of purchasing power from inflation, it is important to focus on investment returns in excess of inflation (i.e. real returns). • Equities have delivered returns comfortably in excess of inflation while fixed income’s returns were barely above inflation over a long period of time. • Equities offer superior inflation protection over traditional fixed income, albeit with far greater volatility. 4 Ten Year Treasury Yield 10-Year Note Yield
  5. 5. Experience Insight Impact What May Change Going Forward? 5 Yield Difference: U.S. 10 Year Note – 10 Year TIPS Source: Bloomberg Going forward, there are a number of reasons to believe inflation may accelerate from the roughly 2% rate that we see today. • A border tax would likely raise prices on many foreign goods • A falling unemployment rate with tight labor market conditions • Prospects for deregulation that would stimulate economic activities • Fiscal stimulus (e.g. infrastructure spending) • The Fed’s pace of raising rates is slower than the market expectations In fact, inflation expectations have been steadily rising.
  6. 6. Experience Insight Impact How Could Higher Inflation Impact the Real Economy and the Financial Markets? 6 Low, stable, expected inflation is not bad for the economy. Deflation hurts the economy as it encourages economic participants to delay purchases in expectations of prices going lower. As a result, economic activities decline. The best example is Japan, illustrated on the left. Stagnant CPI has largely coincided with growth-less GDP levels. Unexpectedly, accelerating inflation reduces households’ real income and in general shrinks corporate profit margins. However, as previously discussed, higher inflation makes holding cash very difficult as investors will face negative real returns in a near-zero interest rate environment. Japan Nominal GDP Japan CPI Source: Bloomberg
  7. 7. Experience Insight Impact How Could Higher Inflation Impact the Real Economy and the Financial Markets? 7 S&P 500 CPI %∆YOY Source: Bloomberg Despite clear long-term outperformance of equities in excess of inflation, periods of high accelerating inflation beyond expectations may result in a weak economy and markets. This experience was demonstrated in the 1970s, due to unexpected higher prices, which reduced real income and shrunk profit margins.
  8. 8. Experience Insight Impact Investing During A Rising Rate Environment 8 Over the long-term, equities (and other tangible assets) have served as effective inflation hedges. Within the fixed income category, floating rate loans and shorter term bonds have outperformed during inflation. These instruments have the ability to reset to the higher rates which accompany inflation. S&P 500 CPI %∆YOY
  9. 9. Market Perspective – February 2017 Experience Insight Impact biegelwaller.com Conclusion: Given the current policy goals and objectives in Washington, the potential for higher inflation exists. In the short run, this could make “holding cash” (which earns very little) more difficult for investors. Flexibility and risk management remain essential to the investment process in order to adapt to the rapidly changing landscape under the new administration. 9
  10. 10. Experience Insight Impact Disclaimer Opinions expressed in this commentary may change as conditions warrant and is for informational purposes only. Information contained herein is not intended to be personal investment advice for any specific person for any particular purpose. We utilize information sources that we believe to be reliable but cannot guarantee the accuracy of those sources. Past performance is no guarantee of future performance; investing involves risk and may result in loss of capital. Consider seeking advice from a professional before implementing any investing strategy. 10

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