IN FL ATION —TH E GOOD, TH E BAD, AN D TH E UG LY

2 Inflation–The Good, The Bad, and The Ugly

TA B L E O F CO N T E N T S

In this white paper: Contributors:

Background—What is Inflation?

When is Inflation Helpful?

What if Inflation is Too Low?

Interest Rates and Inflation During and After the Financial Crisis

Secular Factors Weighing on Inflation

Cyclical Inflation Forces

Conclusion: Portfolio Positioning

Adam I. Taback 3 Chief Investment Officer,

4 Wells Fargo Private Wealth Management

5 Douglas W. Evans, CFA® Senior Managing Director of Asset Management, Abbot Downing 6 Marc A. Doss, CFA®, CFP® 7 Regional Chief Investment Officer,

8 Wells Fargo Private Bank

10 Carol M. Schleif, CFA® Deputy Chief Investment Officer, Abbot Downing

Roger W. Adams, CFA® Business Support Consultant, Asset Management, Abbot Downing

Julie A. LaViolette Investment Associate, Asset Management, Abbot Downing

Inflation–The Good, The Bad, and The Ugly

INFLATION—THE GOOD, THE BAD, AND THE UGLY “Inflation is as violent as a mugger, as frightening as an armed robber, and as deadly as a hit man.” – Ronald Reagan

Our 40th president can probably be forgiven for his dramatic depiction of inflation given the proximity of his presidency to the atypically heightened levels of inflation and interest rates experienced throughout much of the 1970s and early 1980s (see Chart A). While it’s true that inflation’s influence can be insidious—inexorably gnawing away at purchasing power over long time periods—moderate inflation is arguably a good thing, indicating a healthy and sustainably growing economy.

Chart A: Consumer Inflation

Per

cent

15.0

12.5

10.0

7.5

5.0

2.5

0.0

-2.5 1970 1980 1990 2000 2010

Shaded areas indicate U.S. recessions

Source: World Bank.

On a secular basis, headline inflation has been remarkably low since well before the financial crisis, confounding policy makers at the U.S. Federal Reserve and other central banks around the globe who would prefer to see a run rate closer to 2%. Arguably, it has been two or three generations since corporate leaders or consumers have had to operate in an inflationary environment (remember FIFO and LIFO accounting and 5% annual salary/cost of living increases?)—meaning it’s not even in the frame of reference for many. Yet inflation is an important topic to consider both short and long term, given its influence

on everything from standard of living, pricing power, and wealth accumulation to fiscal and monetary policy at the highest levels. This paper will address: 1) the secular history, influence, and experience of inflation; 2) why we care about inflation in the first place; 3) cyclical issues that may reverse some of the longer secular trends; 4) the risks of disinflation or deflation; and 5) portfolio positioning thoughts relative to various potential scenarios.

Table 1: Inflation Considerations—Secular (long cycle) and Cyclical (shorter term)

Secular Considerations Cyclical Considerations

50-Year Low U.S. Technology

Unemployment Rate

Globalization and Trade Low Interest Rates

Aging Demographics Government Deficit Spending

Reversal/Stalling of Lower Inflationary Expectations

Key Secular Trends

Background—What is Inflation?

According to Investopedia, inflation is defined as “a quantitative measure of the rate at which the average price level of a basket of selected goods and services in an economy increases over a period of time .... Often expressed as a percentage, inflation indicates a decrease in the purchasing power of a nation’s currency.”1 Much of modern financial theory and many financial transactions—such as capital asset pricing models, the discount rate used to evaluate mergers and acquisitions (M&A), capital market assumptions (CMAs), cost-of-living increases, and loan rates— are based on some level of expectation for what an inherent rate of inflation is or is expected to be. Given that even moderate inflation grinds away at purchasing power every minute of every day, it is necessary to factor its potential impact on business and personal financial decisions. While prognosticators are notorious for having difficulty predicting levels of interest rates—or even short-term directionality—it is important to consider

3

Inflation–The Good, The Bad, and The Ugly

250

factors that may influence interest rates, pricing Chart B: Global Aggregate Negative Yielding Debt power, and policy.

16 When is Inflation Helpful?

14

While investors and citizens often have a knee­ 12 jerk negative response to the concept of inflation,

Trill

ions

($

)

10moderate inflation allows companies “pricing power” or the ability to increase average selling 8

prices year-over-year. This, in turn, facilitates 6

wage growth and the chance for consumers and employees to improve (or at least maintain) their lifestyles. When inflation rates are closer to the long-term average (historically between 2.5% and 3%), investors with funds parked in what are typically viewed as the most conservative investments (such as money market accounts and short-term U.S. Government Securities) have historically been able to earn a moderate return. When normal returns are not available, such as since the 2008 financial crisis when global central banks intervened in the debt markets and pushed much of the world’s sovereign bond yields into negative territory, investors looking for yield are forced to range further afield to generate like returns, taking on more potential risk in the process. (see Chart B)

For evidence of this aversion to even a whiff of inflation, one has to look no further than the volatility induced in the nearly 10% stock market pullback experienced in early February 2018 when

Chart C: Price Changes by Category

4

2

2009 2010 2011 2012 2013 2014 2015 2016 2017 2018

Source: Bloomberg, LLC.

the jobs report spooked investors into believing the inflation genie was out of the proverbial bottle. The media angst and interim market volatility prompted by the U.S. 10-year Treasury note yield flirting around the psychologically important 3% level lends further credence to that belief. So, if inflation is arguably “good,” why do market participants seem to fear it so much?

In the near term, we suspect part of the answer lies in unfamiliarity. While certain sub-segments of the economy like healthcare, education, and select service categories have experienced above-average price increases over the past 20 years, the economy as a whole has not (see Chart C).

Selected U.S. Consumer Goods and Services, and Wages

Hospital Services

200

150

100

MORE EXPENSIVE

MORE AFFORDABLE

Overall Inflation (36.07%)

College Textbooks

College Tuition

Medical Care Services

Child Care

Wages

Food and Beverages

Housing

New Cars

Clothing

Household Furnishings

Cellphone Service

2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017

Source: Bureau of Labor Statistics, data as of 5/15/18.

Computer Software Toys

TV’s

4

50

0

5 Inflation–The Good, The Bad, and The Ugly

Behavioral scientists teach us that we tend to tether our expectations of the future most tightly to what our most recent experience has been. Folks buying homes in 2001 for example, attained 30-year mortgage rates of 7.4% on average, according to data provided by Freddie Mac.2

While today’s homebuyers would undoubtedly find it shocking to pay such rates, a 2001 purchaser was likely feeling pretty smug relative to someone who had signed a contract a mere 12 months prior when average rates were over 8%. Context and perspective are typically driven most forcefully by proximity. Between 1950 and today, inflation as measured by the Consumer Price Index (CPI) has averaged 2.95%.3 Over the past decade, however, the rate has been closer to 2% or less. Proximity makes it feel as if 2% is the norm, especially since the U.S. Federal Reserve has been struggling for months/years to even get it near that level.

On a broader basis, we suspect that the boomer (and older) generation(s) subconsciously presume that if the inflation bogeyman does reassert itself, it will revert to the type of double-digit inflation that so terrorized the 1970s, peaking in 1981 with 15% long-term Treasury rates4 and oil priced at over $133 per barrel.5 Given the trauma that double-digit inflation, price controls, and a variety of other business-unfriendly policies wreaked during the formative years of wide swaths of the current citizenry, it’s perhaps understandable that even the word “inflation” conjures negative connotations.

This notion that a moderate, sustained upward

What if Inflation is Too Low?

Another way to think about inflation is to consider its alter-ego: deflation. While falling prices on individual items sound good from a consumer standpoint, when an entire economy is deflating, it is widely viewed as unhealthy. Deteriorating prices can imply soft demand, increasing unemployment, sinking wages, and lackluster or negative corporate growth rates.6 If prices are falling, it tends to weigh on economic progress, pushing out purchasing decisions given the belief that prices will be cheaper later. The Japanese experience subsequent to its 1980s stock market bubble is often pointed to as the textbook example (see the next three charts).

Chart D: Inflation, consumer prices for Japan

25

20

15

Per

cent

5

0

-5 1970 1980 1990 2000 2010

Source: World Bank.

Chart D: Leading Indicators OECD: Reference Series: Gross domestic Product: Original Series for Japan

10

bias to prices is helpful is what central bank policy is arguably all about. All else being equal, moderate rates of inflation coupled with a stable regulatory and lower tax environment can promote a virtuous cycle of pricing power; increased investment in research and development (R&D); solid employment; and confident consumers willing to spend, invest, and keep the cycle moving.

Gro

wth

Rat

e Sa

me

Per

iod

Pre

vio

us Y

ear

10

5

0

-5

15

-10 1970 1980 1990 2000 2010

Source: Organization for Economic Co-operation and Development.

6 Inflation–The Good, The Bad, and The Ugly

Chart D: Nikkei Stock Average, Nikkei 225

Ind

ex

40,000

36,000

32,000

28,000

24,000

20,000

16,000

12,000

8,000

4,000

0 1950 1960 1970 1980 1990 2000 2010 2020

Source: Nikkei Industry Research Institute.

Interest Rates and Inflation During and After the Financial Crisis

When the financial bubble burst in 2008, central banks around the globe stepped in with unprecedented measures to provide liquidity and support to the financial system in the hopes of staving off an even worse crisis. When policy rates were cut to zero and growth still remained

Chart E: Federal Reserve Bank Credit

sluggish, the European Central Bank (ECB) and others took the experimental and unprecedented step of pushing rates even lower—to below zero— and keeping them there. At one point during 2019, over $17 trillion in global debt sported yields below zero.

For its part, the U.S. Federal Reserve, rather than follow a “ZIRP” (Zero Interest Rate Policy), chose to expand its balance sheet by buying fixed-income securities all along the curve to inject additional cash into the system. This strategy, dubbed “quantitative easing” (QE), was deployed a number of times to keep financial markets well lubricated (see Chart E). The hope was that the strategy would help propel the overall rate of inflation toward the Fed’s target rate of 2%. Unfortunately, through much of this period, other outside stressors (e.g., clearing balance sheets and righting the vast quantity of foreclosures and bankruptcies in the system) and substantially increased regulatory oversight slowed the velocity of the excess liquidity, failing to move the inflationary needle as far as the Fed had hoped.

Weekly 7/03/2008 – 1/31/2020 (Log Scale)

25 Total Reserve Bank Credit as a % of GDP 1/31/2020 = 18.9% Scale Left ( )

Total Reserve Bank Credit Jan. 40 35

1/31/2020 = $4115.2 Billion Scale Right May 25 20

( )

Fed Buying in $Billions

2014 TSY MBS

Feb. 35 30 Apr. 30 25

July 20 15 Aug. 15 10 Oct. 10 5 Nov. 0 0

4269

22 3237

21 2454

18

1861 15

12 1441

9 1070

6 Source: Federal Reserve Board. 811 S D M J S D M J S D M J S D M J S D M J S D M J S D M J S D M J S D M J S D M J S D M J S D

2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 2020

4000

3500

3000

2500

2000

1500

1000

500

Securities Held Outright Total 3793.5 Treasury 2397.4 MBS 1393.8 Agency 2.3

In $ Billions

OE 1 Begins: 500 MBS 100 AGY

OE 1 Expanded to: 1250 MBS 200 AGY 300 TSY

End TSY Buys

End of OE 1

OE 2 Begins: 600 TSY

OE 2 Ends

Twist Begins 400 TSY

Twist Extended to 12/31/12

267 TSY

QE 3 Expanded 45 TSY

QE 3 Begins: 40

MBS

Fed Taper

Begins 5 MBS

-5 TSY:

OE 3 Ends

Quantitative Easing = Open market Operations to support the functioning of credit markets through the purchase of longer-term securities for the Fed’s portfolio

Fed Balance Sheet Reduction Begins

Fed Balance

Sheet Reduction

Ends

Fed Begins purchasing T-Bills

at $60b per month

4000

3500

3000

2500

2000

1500

1000

500

Securities Held by The Federal Reserve.

Inflation–The Good, The Bad, and The Ugly

Secular Factors Weighing on Inflation

Through much of the 20th century as the U.S. transitioned from an agricultural to a manufacturing-based society, the economy became prone to sharp economic swings—both up and down—primarily driven by changes in the manufacturing and inventory cycles (see Chart F depicting GDP growth and recessionary periods). Inflation often accompanied upswings, given bottlenecks and supply/demand imbalances in key components and portions of the manufacturing cycle.

Chart F: Real Gross National Product

Per

cent

Cha

nge

fro

m Q

uart

er O

ne Y

ear

Ag

o

15.0

12.5

10.0

7.5

5.0

2.5

0.0

-2.5

-5.0 1950 1960 1970 1980 1990 2000 2010

Shaded areas indicate U.S. recessions

Source: U.S. Bureau Of Economic Analysis.

In more recent decades, the advent of increasingly cheap and abundant computing power has wrought massive changes in business models, supply chains, and global logistics. As the cost of computing power plummeted and connectedness and usage became ubiquitous, the ability to pass price increases along largely stopped (it's hard to remember what life was like before smart phones). Think of all the transactions and research that is now conducted with a few thumb presses relative to, say, 2000. The first iPhone was launched in 2007!

Consumers and businesses alike were increasingly able to take research and astute comparison shopping into their own hands. Suppliers, wholesalers, and retailers throughout the value chain were forced to adapt to survive. Manufacturing was offshored to locales with cheaper labor; continual business process

improvement became a life or death corporate mantra; and key distributors such as Walmart and Home Depot were able to set macro trend objectives like the implementation of RFID7 and just-in-time delivery for its suppliers to adhere to, irrevocably changing business landscapes in the process.

Chairman of the U.S. Federal Reserve, Jerome Powell, and other Fed officials have frequently spoken with consternation about the current environment of low unemployment and the failure of inflation to return to the higher levels that would theoretically be expected. Part of the conundrum may be answered by shifting demographics as more highly compensated baby boomers exit the work force in large numbers while larger cohorts of Millennial and Gen Z workers enter at lower overall wage rates (See Table 2 and Chart G).8 Additionally, the work force participation rate has also started to tick up for the first time since the late 1990s (see Chart H), potentially making the unemployment rate a tad misleading.9

Table 2: U.S. Population Distribution by Age Group (as of 2017)

Age 2017 Population

Under 5 years of age 19.94 million

5 to 14 years 41.08 million

15 to 24 years 43.25 million

25 to 34 years 45.34 million

35 to 44 years 40.88 million

45 to 54 years 42.37 million

55 to 64 years 41.10 million

65+ years 50.86 million

Source: U.S. Census Bureau data.

7

8 Inflation–The Good, The Bad, and The Ugly

Chart G: Estimated Change in Population by Age Cyclical Inflation Forces Group 2020 to 2030

The strong structural forces in place today— including sluggish global growth and low-to­negative interest rates around the globe—seem to imply the inflation rate could remain low. Are there any countervailing cyclical forces that could start to push inflation back up? Historically, some cyclical forces have tended to push inflation higher. For example, the combination of low unemployment, low interest rates, and high government spending tend to push inflation higher. Whether these cyclical forces will be strong enough to overcome the structural forces of lower inflation or disinflation is difficult

Tota

l Po

pul

atio

n C

hang

e (I

n Th

ous

and

s)

3,000

0

-3,000

9,000

6,000

12,000

239 166

6,110

2,015

-3,443

6,151

11,515

Under 25-34 35-44 45-54 55-64 65-74 75 and over 25

Source: 2018 Ned Davis Research, Inc.

Chart H: Labor Force Participation Rate

68

67

66

Per

cent

65

64

63

62

61

60

59

58 1950 1960 1970 1980 1990 2000 2010 2020

to determine.

The U.S. unemployment rate (see Chart I) is at a 50-year low. Historically, this has resulted in higher wages which tends to be inflationary. This relationship is what economists call the Phillips Curve. It is a fairly straightforward concept of supply and demand. As the unemployment rate declines, workers can demand higher wages since there are fewer qualified people available for employers to hire. Their bargaining position improves and they start to capture higher wages. Chart J shows how much the unemployment rate (top line) has come down versus average hourly worker earnings (bottom line).

Shaded areas indicate U.S. recessions Chart I: Unemployment Rate Source: U.S. Bureau Of Labor Statistics.

11

Noticeable changes in the number of millennials 10

moving into prime housing years, boomers 9

moving into retirement, and the substantial

Per

cent

8

reduction in Gen X in the typically highest earning 7

age ranges could well be exerting inflationary 6

influence on various subsectors. For example, housing prices are being pressured by increased demand, but lower supply generation; health care being pressured by increased demand from a growing contingent; and lack of individuals in the critical wage-earning years having a depressive effect on overall wages.

5

4

3

2 1950 1960 1970 1980 1990 2000 2010 2020

Shaded areas indicate U.S. recessions.

Source: U.S. Bureau Of Labor Statistics.

9 Inflation–The Good, The Bad, and The Ugly

Chart J: Will Job Gains = Wage Gains?

Per

cent

6

5

4

3

1 2011

10

9

8

7

11

2013 2015 2017 2019

2 2.9%

3.5%

U.S. recessions U.S. average hourly earning (YoY%)

Unemployment rate

2009

Source: Bloomberg, December 31, 2019.

So far, the normal rule of the Phillips Curve has been muted, but the chart above may be reaching a point where wages will rise more rapidly.

The laws of supply and demand are not dead, but may be dormant for other reasons. One reason is the labor force still has more supply available than the published numbers would indicate. Many people dropped out of the labor force as a result of the global financial crisis. Others remained in jobs they were overqualified for. Now some of these workers have started to re-enter the labor force as demand for their services continues to rise in a tighter labor market.

Some measures of wage gains have started to increase above trend. For example, wage gains for unskilled labor had remained low for much of this recovery but are starting to rise.10 These numbers indicate that the law of supply and demand is not dead but may simply require tighter labor markets. As the U.S. economy continues to run at a very low rate of unemployment, wages could start to increase at a much faster pace.

Another issue is that not all of the structural forces keeping inflation low will remain in place indefinitely. Some could even reverse. Consider globalization and trade. Many of the key forces behind globalization have pulled inflation lower (for example, supply chains turning to China and other emerging markets for cheaper electronic goods). Outsourcing jobs to emerging markets has affected not only manufacturing jobs but also

services. A global labor force has made it more difficult for white collar workers to bargain for higher wages, which also puts further downward pressure on inflation.

There are some key countervailing forces taking shape today. Consider both the UK and the U.S. Both countries have long traditions in favor of free trade. Under Brexit, the UK exited the European Union (EU) at the end of January. While the UK continues to support free trade in general, it is breaking away from the EU trading union. If the UK does not stay in the EU customs union—which is under negotiation—it may result in higher trading costs for both the UK and EU. The EU would impose tariffs on the UK that were not in place for decades. The UK would likely reciprocate with tariffs on EU goods. The process could, at least in the short term, result in a reversal of globalization and increase costs for consumers. This could increase inflation, though how companies choose to deal with it remains to be seen. A mix of corporate absorption and modest price increases would likely be the result—much as we have seen in the U.S. in the wake of the nearly two-year-old trade war with China.

The U.S. has similarly backed away from its nearly unfettered support of global trade. Instead, the U.S. is using tariffs to negotiate deals with individual countries such as China, Japan, Mexico, and Canada as well as the EU. While a Phase 1 trade deal is completed with China, U.S. tariffs will remain on $370 billion in Chinese exports to the U.S. While some may argue the end goal is freer and more open trade, tariffs are a cost that may prompt inflation to move higher, depending upon each company’s decision on how much of the increased cost to absorb versus push to customers. In the short run, the benefits of globalization such as low cost of consumer goods, may have peaked and could be reversing.

While the overall metrics that measure inflation remain low, it is also important to consider the rise of asset prices around the globe during this longest ever U.S. economic expansion. Low and even negative interest rates have caused investors to increase risks and buy assets such as stocks. Stocks in the U.S. are at or near all-time highs and have significantly outpaced inflation on an annualized basis by a multiple greater than five

10 Inflation–The Good, The Bad, and The Ugly

times. Real estate prices around the globe have also significantly outpaced inflation and income growth. In addition, while many goods such as electronics have decreased in price relative to inflation, the costs of key purchases have risen dramatically. For example, housing, health care, and college tuition costs have risen much faster than inflation during this economic expansion. Traditional measures of inflation may not be rising dramatically, but the costs that matter to many people are.

Conclusion: Portfolio Positioning

High inflation is one of the most damaging forces facing investors. It negatively impacts the long­term purchasing power of a portfolio. As people live longer and enjoy much longer retirements, inflation is an even more important factor for any investor’s long-term financial plans. Consider if inflation were to rise back to 3%. At 3%, the long-term purchasing power of a portfolio would be cut in half in 24 years. Many people will enjoy 24 years of retirement, so the risk associated with inflation cannot be ignored.

While inflation has averaged 2% or less over the past decade, we assume a slightly higher rate of 2.5% in our long-term capital markets assumptions published annually by the Wells Fargo Investment Institute (WFII). This builds in some cushion if inflation rises. We believe it is better to factor in slightly conservative assumptions when building portfolios.

Inflation remains low for many of the structural reasons discussed in this paper. There are definitely risks that some of these structural forces may have peaked or could reverse. In addition, there are powerful cyclical forces that could begin to push inflation higher. In either case, we believe investors should prepare their portfolios for higher inflation. If, in reality, we don’t see higher inflation, then investors may outperform their benchmarks—an upside for investors.

We believe the best way to prepare for higher inflation is to hold diversified portfolios across stocks, bonds, real assets, and alternative investments. The particular mix for any individual will be unique. Stocks and real assets such as real

estate tend to outperform inflation over longer time frames. There are also many alternative investments that can significantly outpace inflation.

For most investors, bonds on the other hand, will not do well if inflation picks up. They would continue to provide stability of principal and income but tend not to perform well in times of increasing inflation. For most investors, bonds remain a key component of their conservative “bucket.” Plus, if we stay in this low interest rate environment, they will continue to do well.

The most likely scenario for investors is that we will remain in a relatively low and benign inflation environment. Strong secular forces could keep inflation low for longer. Cyclical forces may cause inflation to rise over shorter time frames. If inflation does rise and stay higher, it is better to be prepared. The 2020 WFII Outlook, quotes Warren Buffet: Predicting rain doesn’t count: building arks does. The best ark in the investing world is a highly diversified portfolio focused on quality and geared for the long term.

Inflation–The Good, The Bad, and The Ugly 11

Endnotes 1 https://www.investopedia.com/terms/i/inflation.asp

2 http://www.freddiemac.com/pmms/pmms30.html

3 http://www.in2013dollars.com/1950-dollars-in-2018?amount=100

4 https://fred.stlouisfed.org/series/DGS30

5 https://fred.stlouisfed.org/series/WTISPLC

6 https://www.investopedia.com/articles/personal-finance/030915/why­deflation-bad-economy.asp

7 https://en.wikipedia.org/wiki/Radio-frequency_identification

8 https://usafacts.org/data/topics/people-society/population-and­demographics/population-data/population/

9 https://fred.stlouisfed.org/series/CIVPART

10 https://www.cnbc.com/2019/03/13/workers-at-lower-end-of-pay­scale-getting-most-benefit-from-rising-wages.html

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