If Inflation is Fizzling Out, Can Profits Be Far Behind?

*This article was written MFS Chief Investment Strategist, James Swanson. The article was first published and distributed by MFS and has been used with permission.

For decades, experts at the US Federal Reserve, academic economists and portfolio managers have been at war with inflation — the phenomenon of price increases without commensurate productivity gains. Investors and policymakers alike hate inflation because it robs consumers of buying power and discourages money flows into long-term investments for fear that their value will be eroded. The remedy for inflation in past cycles has been for central banks to raise interest rates in order to cool off growth and end speculative investing, thus curbing broad-based consumer price increases. Usually inflation flare-ups occur a couple of years into a cycle, or at mid-cycle at the latest.

This time, the cycle is getting old — very old — but inflation remains surprisingly tame, running well behind previous US cycles. Meanwhile, similar patterns are playing out globally. Chinese inflation is slowing. The eurozone, despite growth that has exceeded expectations, has seen disappointing inflation data of late. Japan is a similar story. Even the UK— which has seen a post-Brexit-vote inflation spike on the back of a weak pound — has witnessed a downtick in prices, according to recent data.

Pricing power and inflation linked

Inflation is inextricably linked to companies’ pricing power. And in the late stages of a cycle, it is usually the ability to raise prices that drives revenues up against a base of fixed costs, expanding profit margins. But inflation remains well contained in much of the developed world, limiting companies’ ability to raise prices.

This time around, the lack of inflation may mean trouble for a market that is more expensive than 90% of previous market periods. As the old saying goes, it is priced for perfection. But already we’ve seen that June US retail sales have disappointed, that car sales and prices are weak and that apartment rents have started to flatten out. This lack of pricing power could negatively impact future sales growth, and could become an increasing discomfort for a market that has known only quarter after quarter of rising stock prices.

One of two problems

In my view, the market faces one of two problems going forward:
1) Historically, inflation and corporate borrowing rise during the late stages of a business cycle. This levers up returns to shareholders — for a while. But at some point, usually before the economic data roll over, the market loses upward momentum and share prices fall because of a deadly combination of tighter monetary policy, decreased investment and flagging profits. If companies lever up,  the cycle typically follows its normal course toward decay and recession, since companies usually increase leverage at precisely the wrong time. And history tells us that risky assets like stocks and high-yield corporate bonds tend to fare very poorly during economic downturns. In fact, the typical decline in the S&P 500 Index during a recession is 26%. That’s a serious hit to anyone’s nest egg.

2) However, this cycle looks atypical, given the lack of latecycle inflation pressures. So if subdued inflation continues to retard pricing power and profit growth, then most companies likely won’t live up to earnings expectations, and stock prices could suffer as a result.

Miracle solution?

Is there a solution to the above two problems? Perhaps inflation comes back, pricing power returns and central banks don’t choke off the moderate global economic expansion now underway. But that’s an outcome I’ve not witnessed during my entire career. Alternatively, we could assume that things really have changed and that the business cycle can extend indefinitely. Or that the US Congress will cut taxes enough to spur a resurgence in economic growth.

However, I’m not buying the notion that business cycles are a thing of the past. Nor am I buying that politicians can make much of a difference. Since I’m not expecting any miracles, I’d rather focus on preserving the huge market gains — on the order of 300% — made since the market low in 2009.

For investors and business cycles, age matters

For investors, age is essential in determining how much risk one can assume. For business cycles, one can say the same. The average business cycle lasts five years, and the cycle we are in today is eight years old. The longest cycle on record is 10 years, so history suggests we’re getting late in the game. The later we get, the more the risks of the cycle coming to an end rise. This is especially important given the aging of the global population. Investors, on average, need to take less risk today than they did a decade ago, and should be particularly mindful of the potential for the cycle to end at any time. Against a backdrop of aging global demographics, slow economic growth and record-high debt levels, investors would be wise to exercise caution rather than taking risks at this late stage of the business cycle.

*This article was written MFS Chief Investment Strategist, James Swanson. The article was first published and distributed by MFS and has been used with permission.