Is Higher Inflation Coming? Hedge Fund Star Griffin Makes a Case

To hedge fund titan Ken Griffin, investors’ proverbial wall of worry has gotten more treacherous, owing to an old nemesis the US and much of the globe hasn’t seen in many years—inflation.

Is he right? He does have a case.

In a letter to investors in his fund, Citadel, Griffin said he is worried about a rise in inflation, which could threaten US and worldwide economic expansion. He warned that “dark clouds potentially loom over the horizon.” And judging by the stock market’s February sell-off, he is far from alone in fretting about increasing prices.

The stock slump appeared to be driven by investor concerns that, amid a tightening labor market and a robust economy, inflation will climb to the point it sets off alarm bells. Then, as the dire scenario goes, the Federal Reserve would jack up interest rates faster than its current gradual pace—thus plunging the world’s largest economy, and the rest of the globe, into a recession.

Griffin, in his letter, pointed to “nascent signs of accelerating inflation in many countries around the world” and lamented what he called “the general complacency around the risks of inflationary shock.” And he noted that the Fed is “raising rates to prevent the economy from overheating.”

To be sure, the Fed has shown concern about coming inflation, given the low unemployment rate (4.1%) and a pick-up in hourly wage rates (2.9%), which indicates that, after years of muted pay growth, labor shortages are developing that employers are dealing with by raising wages. The central bank has indicated it plans to increase rates three times this year, at a quarter percentage point each.

At this stage, headline statistics show some inflation momentum, although it’s hardly rampaging. For 2017, the Consumer Price Index advanced 2.1%, which is higher than the average 1.6% since 2010, the first full year out of the recession. But this isn’t a huge increase—a bigger one, 3.2%, came in 2011, when crude oil prices were spiking.

More recently, the statistics have given a mixed message. For January, the CPI was up 0.5%, versus projections of 0.3%, and on an annual basis, 2.1%, compared to a 1.9% estimate. When the inflation news was announced on Wednesday, the market briefly swooned. Then, though, it finished up more than 1% for the day, as investors reacted to an unexpected decrease in January retail sales, coupled with a revised downward number for December .

Still, as Griffin contended, there are indicators that suggest something more unsettling might be coming. First, take investor expectations, something not to be ignored: In investing, the thought often is father to the deed. The difference between the yields of nominal bonds and inflation-linked ones, of the same maturity, has been ascending for the past seven months. This so-called breakeven rate, tracking inflation expectations for the next five years, rose to 2% annually from 1.54%.

The Cleveland Fed has a measure called the median CPI, which takes the reading of a long roster of price changes and focuses on the data point in the exact center. Known as one of the best predictors of coming inflation, this metric has picked up lately.

Moreover, a survey by the National Association of Independent Businesses found that, as of year-end 2017, employers planned to boost their hiring 20% in the next three months, and over that time span, workers would get raises at a level last seen in pre-recession 2007.

Of course, none of this may come true. An inflation increase from the current point, in the low single digits, may not be as worrisome to the economy as previous inflationary bouts. Chief example: the 1970s, when the CPI was in the mid-teens, a tempo that distorted the economy. The consensus among economists is that 2% per year is an acceptable rate.

The old saying is that Fed rate hikes are often the main catalyst for recessions. That’s not always borne out, however. If the economy is doing well, tighter money often doesn’t reverse it.

During the booming economies of the mid-1960s and mid-1980s, the Fed increased its benchmark federal funds rate. In both cases, stocks took a hit—most notably with the crash of 1987—but the strong economies kept charging. In the economically weaker late-1970s and early-1980s, though, the Fed’s then chairman, Paul Volcker, combated the era’s virulent inflation by lifting the Fed funds rate well past 20%. Recessions ensued in 1980 and 1982.

At other times, the cause-and-effect of Fed rate actions is hard to measure, and may have been negligible. Much like the trend today, the Fed lifted the rate from 1% in 2003—low rates before then were engineered to fight the tech-bust recession—to 5.25% by 2007, when the sub-prime housing debacle was starting. (The Fed promptly set about lowering the rate to near-zero by the end of 2008.) There is no proof that those higher rates were a big factor in creating the financial crisis. Hands down, the rickety state of many mortgages was the trigger.

Nevertheless, as we saw in the mid-1960s and mid-1980s, higher rates do have an impact on the stock market. The low rates since the 2008-09 financial crisis spurred investors to crowd into stocks because they offered far greater returns than bonds. And low rates make borrowing to buy shares much easier.

Investors would be wise to listen closely to Griffin given the track record.

Citadel’s flagship multi-strategy fund has an annualized return of over 19% since inception in 1990. Last year, the firm generated net gains of $3.4 billion, bringing total gains since inception to $28.6 billion – the third highest for all hedge funds, according to LCH investments.

Griffin showed a savvy for markets early, trading convertible bonds from his Harvard dorm room before going on to build one of the most successful investment firms of all time. He avoided the 1987 crash and has weathered many storms over time. If one is coming, he may be the one to have spotted it.