2017 Market Review

2017 looks to have been a banner year for the world’s economy, particularly when considering the relatively lackluster performance of 2016. Economic performance is generally measured in terms of growth in gross domestic product (GDP). World GDP increased about 3% in 2017, a step up from the 2.4% of 2016 and from the 2.8% pace of 2015. Of note, many the world’s major economies - the United States, Japan, and the Euro Area - performed substantially better in 2017 than in 2016. China’s growth was also a bit better in 2017 than in 2016. Looking ahead to 2018, the recently- passed tax legislation in the United States should push up growth for this year as well.

While GDP growth is a definite positive - it means that an economy is producing more - an extended period of overly strong growth has a potential downside: an increase in the rate of inflation. The inflation rate is the percentage increase in the general price level from one period to another, commonly over the course of a year.

Inflation makes goods and services more expensive. Overly strong GDP growth may lead to inflation because the resources needed to produce the additional goods and services will likely demand higher payments. For example, workers may be able to command higher wages if their labor is in high demand. Raw materials, such as oil, will be needed by many producers, who will be willing to pay more for these resources. As the prices of labor and other things used to produce output go up, the prices of end products will likely also increase, as firms need to recoup their higher costs of production.

Inflation also has an impact on interest rates and bond prices. As prices go up, the purchasing power of a unit of currency, say one US dollar, goes down - a consumer is not able to buy as much with that dollar as before. Given that a dollar is expected to be worth less over time, lenders will demand a greater return on their loans, thus pushing up interest rates. Bond prices will tend to fall, since bond prices move inversely to their yields, or interest rates.

Inflation also affects stock prices. In the broadest sense, a firm’s stock price is determined by its operating profits (technically, its operating cash flows). Inflation tends to push up future cash flows. The costs of a firm will increase as labor and capital prices increase. However, revenues will also increase because a firm will charge higher prices and push through the higher costs to customers. The net result is that operating profits will increase at the rate of inflation, and therefore the stock price should increase by the rate of inflation as well.

However, an effect like that which occurs with bonds also takes place. Due to higher inflation, a dollar of operating profit is expected to be worth less over time, and investors will demand a greater return on their investments, thus pushing up “interest rates,” or required returns on equity. As the required returns go up, stock prices will drop, just as bond prices drop when interest rates (required returns on debt) increase.

Therefore, the effect of inflation on stock prices is not clear. Inflation tends to push up future operating cash flows of a firm. On the other hand, it also pushes up the return on equities expected by investors. Ultimately, the relationship between inflation and a stock price will depend on which of these two forces dominates.

In the money management world, inflation is one of the toughest risk factors to deal with (hedge against). While it is known that inflation will cause current bond prices to drop, inflation can also push up or down the current prices of most other securities, like stocks and commodities. With this ambiguity, money managers debate ex-ante how to structure a portfolio to protect against inflation risk.