Increasing Inflation Is the 800-Pound Gorilla in the Room

NEW YORK (TheStreet) -- The doomsday crowd has been gnashing its teeth about inflation for years.

After the passage of the Troubled Asset Relief Program and the Federal Reserve's Quantitative Easing programs, the inflation paranoia even crept into the mainstream. It seemed a virtual certainty the country was headed for runaway inflation.

Today, after five years of incontrovertible evidence showing hardly any inflation, the market now appears to have discounted the possibility entirely.

Stocks command premium valuations and display impressive technical resilience. Treasury yields are locked in a historically low range while bonds at the short end of the curve pay investors a negative real yield. Gold has collapsed 40% from its highs while commodity indexes like the CRB have gone essentially nowhere for years. Real estate, for all its price recovery lately, still shows activity far below normal.

This is not how any of these assets are supposed to behave when inflation is on the horizon.

Markets never change on consensus. Trends turn around only when we believe it's a near-guarantee they'll keep going in the same direction they have been. Clearly, the markets believe the trend of "non-inflation" will be continuing indefinitely.

This is why we're so quick to dismiss the latest data points. In the last few months producer prices have increased at the fastest rate in a year and a half. The consumer price index (CPI) increased 1.4% in the first quarter, an annualized rate well over 5%. The market doesn't seem to care.

But the markets get it wrong a lot. It's also slow to react. The earliest warning signals always come from where few pay attention.

Right now, that's wages. One of the reasons why price inflation never ran out of control as predicted is because wage inflation wasn't there to support it. Wages are what keep prices afloat. Evidence is now emerging that wage inflation may finally be picking up.

According to the NFIB, the number of companies planning to increase workers has nearly doubled in recent months. This correlates almost perfectly with actual increases in year over year compensation, as one would expect.

When you add to that a 1.8% year over year increase in hourly earnings and increasing political pressure to raise the minimum wage, it suggests a wage dynamic that could finally be on the verge of changing. This is a trend that matters a great deal for investors.

Here's why:

Higher wages can fuel higher price inflation.

Higher price inflation means a potentially more aggressive Fed and interest rates above what the market may be expecting.

Higher interest rates have myriad implications in the market. They stiffen the competition for equities as an asset class, negatively impact corporate earnings, and make it tougher to grow by way of leverage. If rates go too high too quickly, not only do they take the luster off stocks, they can trigger a slowdown in economic growth.

With expectations shifting towards meaningfully higher increases in wages, perhaps we shouldn't be so quick to shrug off those latest CPI and PPI data. Perhaps the first quarter really may be indicative of what's to come? Perhaps higher interest rates and higher inflation are waiting on our doorstep?

So as an investor, what do you do?

The playbook for high-inflation environments is less obvious than you'd think. Here's an extensive guide, but I'll sum it up as follows:

  • Holding too much cash is a bad idea.
  • When it comes to bonds, keep your duration short.
  • Wage inflation is awesome for workers, but it puts pressure on corporate earnings and makes equities more dangerous.
  • Companies and sectors with superior pricing power make for better-performing stocks.
  • I may be a housing bear right now, but real estate can be a fantastic place to hide during inflationary periods. Investors get protection from inflation by way of higher home prices and also can increase rents to keep pace.
  • Gold is incredibly volatile and doesn't always rise with inflation.

Keep this playbook in mind if future inflationary data continue to heat up.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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