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Posted on FEB 20, 2018

Johnson Bank Wealth Weekly Investment Commentary | Tuesday, February 20

This is part of an ongoing series of Weekly Commentary articles published by Johnson Financial Group.
This week's issue is written by Brian Andrew, SVP, Chief Investment Officer.

The Inflation Boogeyman

As volatility has returned to stock and bond markets, investors are looking for reasons to be optimistic or fearful. The topic dominating the fearful group is inflation. Investors and consumers alike abhor inflation because it eats into investment returns and income through rising prices. Today we'll look at whether or not there is reason to be as fearful as asset price volatility in the last two weeks would have us believe.

Some Inflation History

Over the last several years, the average rate of price inflation for consumers has remained stubbornly low. In a normal business cycle (if there is such a thing), acceleration in economic growth causes prices to increase, raising the absolute level of inflation.

The chart below shows a measure of inflation over two time horizons – the Core Consumer Price Index (CPI) year‐over‐year and the six‐month annualized rate. The core rate eliminates the more volatile food and energy components. Looking at these two time frames provides some information about whether the core rate is accelerating or decelerating on a nearer term basis. You can see that the six‐month annualized rate bottomed in mid‐2017 and has been accelerating ever since. In fact, the level reached with last week's report is the highest since 2011. You can see that the year‐over‐year rate is less volatile during the period represented. You can also see that it has generally remained below 2% for most of this period, although it began to move higher in mid‐2017. This trend is what has investors nervous.

The dotted line on the chart represents the Federal Reserve Bank's target inflation rate of 2%. The Fed would like to see some positive price inflation because it represents a healthy economy – too little or too much inflation is a problem.

A graph showing the Core CPI 6 month annualized compared to Core CPI year over year in alignment with the Fed's target.

Source: Thomson Reuters Datastream. Through February 14, 2018.

One of the key reasons investors are concerned with the level of inflation is that higher inflation can lead to higher interest rates. We know the Federal Reserve is already raising short‐term interest rates. It has raised rates five times since December of 2015. Coming into 2018, the market's expectation was that the Fed would increase rates two to three more times by .25% each time. Now, the higher rate of inflation has some concerned that it will add a fourth increase. With U.S. and global growth having picked up in 2017, there is concern that inflation, too, will continue to rise at an accelerating rate.

Bond investors in particular worry that intermediate and long‐term interest rates may rise at a more rapid pace. We've seen this since January 1, with the 10‐year Treasury yield moving up to almost 2.9% from 2.4% while 30‐year Treasury bonds have moved from 2.7% to almost 3.2%.

Higher yields generally lead to slower economic growth with a lag. It is possible that the yield boost in late 2016 and early 2017, coupled with the increase we're seeing in interest rates now, will temper growth later in 2018 and ease inflation pressures.

While yields have risen, there is other data to look at besides inflation data to determine its future course.

What Does the Data Say?

There is no doubt that inflation data has been coming in stronger. As mentioned earlier, last week's CPI data reflected stronger growth. However, you have to look a little deeper at the inflation report to understand what segments of the economy are pushing inflation higher and determine whether those higher rates are sustainable.

If you look at last week's CPI report, you can see that the largest contributors were energy commodities. Inflation in this segment of the economy was up 5.5% year‐over‐year. The shelter category was up 3.2% and transportation services were up 4%. However, food was up only 1% and medical services were up 2%.

Because energy occupies a large percentage of the index, the change matters more. Oil prices rose throughout 2017, and the resulting higher gas and fuel oil prices caused the greater than 5% jump. Of course, that is backward looking, and to assume that the inflation rate stays as high would suggest that oil prices need to climb another 57% this year, raising the price of oil above $100. That seems unlikely, as shale oil producers have found the higher price of crude helpful as they bring new production on line. In 2018, U.S. oil production will be higher than it has been since the early 1970s and will likely exceed 10 million barrels per day. The chart below provides a historical perspective.

A graph showing the US oil production in millions of barrels per day from 1920 to present.

Source: EIA. Note: Figures for the two most recent months are estimated using month-on-month growth rates from weekly data.

Structural and Cyclical

Things like a near‐term change in interest rates or an increase in oil prices have a cyclical effect on inflation. In other words, their influence comes and goes over shorter periods of time. Structural effects are more lasting and should not be forgotten by investors during a cyclical upturn in the rate of inflation, particularly if those structural forces are negative or pushing down on the rate of inflation.

The Amazon web site is still up and running! If this is so, then the deflationary impact of price discovery online must also be working. We've written in the past about the deflationary forces that come from using online services to buy goods. The “Amazon Effect” phrase has gained popularity to describe the way in which consumer online behavior may lead to lower prices and inflation. Because we are still in the early stages of universal adoption of this model (less than 10% of retail sales are online), there is likely going to be a continued downward pressure on inflation as consumers focus more on price than they do on brand.

A graph showing e-commerce retail sales as a percent of total sales from 2006 to present.

Source: FRED. fred.stlouisfed.org

Boomers still matter. That is to say, the deflationary effect of the aging demographic group known as baby boomers may also continue to have a downward impact on inflation. As boomers age, their spending habits change and their consumption rate declines. As this happens, the generation to replace them in numbers, the millennials, are still moving through their transition period. At an average age of 26, with an average student loan debt rate near $25,000, they are not committing to families and houses at the same rate as their baby boomer or Gen X parents, which could result in slower consumption not fully replacing the boomer decline. Ultimately, this will resolve itself but may still take a little time.

The structural forces that may reduce the level of inflation such as the Amazon Effect and the aging boomers could overcome or at least limit the cyclical forces raising inflation. At best, we believe the balance may favor higher inflation near‐term. Investors, however, may over‐react to inflation expectations, creating cheaper bonds and stocks and a potential opportunity for the patient investor.

Brian Andrew
As Chief Investment Officer, Brian Andrew leads Johnson Financial Group's investment strategy
to provide consistent, actionable investment solutions for our clients.

This information is for educational and illustrative purposes only and should not be used or construed as financial advice, an offer to sell, a solicitation, an offer to buy or a recommendation for any security. Opinions expressed herein are as of the date of this report and do not necessarily represent the views of Johnson Financial Group and/or its affiliates. Johnson Financial Group and/or its affiliates may issue reports or have opinions that are inconsistent with this report. Johnson Financial Group and/or its affiliates do not warrant the accuracy or completeness of information contained herein. Such information is subject to change without notice and is not intended to influence your investment decisions. Johnson Financial Group and/or its affiliates do not provide legal or tax advice to clients. You should review your particular circumstances with your independent legal and tax advisors. Whether any planned tax result is realized by you depends on the specific facts of your own situation at the time your taxes are prepared. Past performance is no guarantee of future results. All performance data, while deemed obtained from reliable sources, are not guaranteed for accuracy. Not for use as a primary basis of investment decisions. Not to be construed to meet the needs of any particular investor. Asset allocation and diversification do not assure or guarantee better performance and cannot eliminate the risk of investment losses. Certain investments, like real estate, equity investments and fixed income securities, carry a certain degree of risk and may not be suitable for all investors. An investor could lose all or a substantial amount of his or her investment. Johnson Financial Group is the parent company of Johnson Bank, Cleary Gull Advisors Inc. and Johnson Insurance Services LLC. NOT FDIC INSURED * NO BANK GUARANTEE * MAY LOSE VALUE

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