GMO Quarterly Letter | 3Q 2017

What Happened to Inflation? And What Happens If It Comes Back?

Executive Summary

A year ago, the U.S. economy seemed poised for a significant shift. On one hand, inflation was running at the Fed’s target level, unemployment hovered around most estimates of full employment, and a new president was coming in promising a fiscal boost and policies designed to increase economic growth. On the other hand, after close to a decade of doing everything it could to boost the economy, the Federal Reserve was promising to, if not take away the punchbowl, at least begin diluting the alcohol content. Something looked likely to give, in a way that would give us a significant clue as to whether interest rates would ever be able to go back to the levels that we all used to think of as normal. The year has actually turned out to be more confusing than expected, playing out in a way that did not align with either of our scenarios. This leaves us with continued uncertainty about where interest rates will wind up. But it also leaves me, at least, increasingly convinced that a significant inflation shock would be just about the worst thing that could happen to today’s investment portfolios. Unlike most of history, it seems plausible that a meaningful inflation increase from here would impose worse losses on portfolios than a depression would. Depressions are bad for risk assets and good for high quality bonds. Inflation is very bad for high quality bonds and modestly bad for stocks. Today, not only would bonds do particularly badly given their very low real yields, but stocks could get hit worse than you’d otherwise expect given their high valuations. The saving grace from inflation-driven losses is that they would primarily come from a fall in valuations, not impairments to future cash flows. As a result, we wouldn’t be all that much poorer if we judge by the amount of future spending a portfolio could sustainably support. But the loss of paper wealth could be massive. This doesn’t mean such an inflation surge is inevitable, or even particularly probable. It is, however, something that investors should have in the forefront of their minds when they think about what could go wrong for their portfolios.

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