Fiduciary Trust International


Q1 Perspective: Will Inflation Concerns Derail Growth?

March 2011

Perhaps a staffer at the National Security Agency knew that a roughed-up pushcart vendor in Tunis would shake all Arab governments and push some into history. We certainly did not, except we did know that intolerable conditions often eventually lead to revolt.

Are these tectonic changes as significant for world growth as those of 1991 when the Soviet Union collapsed, freeing nations to pursue productive goals? Arguably much of the vast expansion in global prosperity in the subsequent 20 years would not have occurred, or would have been materially muted, if resources had not been freed from wasteful military spending. The prospect for the Middle East is unlikely to be as dramatic or influential. However, if the current march of events continues, freedom and global growth will have gained another support. Of course the oil price is the lynch pin.

The price of oil, which has spiked recently due to turmoil in the Middle East, actually began rising as world demand picked up in early 2009, after the recession bottomed (CHART 1). Copper is representative of this rising demand, and quite obviously not directly affected in the short term by Mid-East unrest. The big long-term story is that the world is using more oil, along with every other commodity.

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The average world oil price has jumped to $112 as of this writing, triggering lots of discussion about whether the higher energy cost will dampen or reverse the recovery. It is perhaps useful perspective that the oil price is currently still 32% below the $147.72 all-time peak on July 3, 2008. The tight correlation between industrial production, aka jobs, and oil’s price through the 2008 peak indicates that the anxiety is well placed. History suggests that high energy prices will impair profits, leading production to slow or decline if the high price lasts more than a few months.

Should we fear inflation? Of course we should in the abstract. Many of us saw its destructive impact on markets in the 1970s. History may repeat. We are watchful and quite prepared to adjust portfolio exposures to protect or benefit from a climate where costs are rising faster than companies can raise prices.

In 1982 Milton Friedman wrote in Capitalism and Freedom, “The recognition that substantial inflation is always and everywhere a monetary phenomenon (emphasis mine) is only the beginning of an understanding of the cause and cure of inflation. The more basic questions are: Why do governments increase the quantity of money too rapidly? Why do they produce inflation when they understand its potential for harm?

“Before turning to those questions, it is worth dwelling a while on the proposition that inflation is a monetary phenomenon. Despite the importance of that proposition, despite the extensive historical evidence to support it, it is still widely denied—in large part because of the smoke screen with which governments try to conceal their own responsibility for inflation.

“If the quantity of goods and services available for purchase—output, for short—were to increase as rapidly as the quantity of money, prices would tend to be stable. Prices might even fall gradually as higher incomes led people to want to hold a larger fraction of their wealth in the form of money. Inflation occurs when the quantity of money rises appreciably more rapidly than output, and the more rapid the rise in the quantity of money per unit of output, the greater the rate of inflation. There is probably no other proposition in economics that is as well established as this one.”

Today it is worth reconsidering Friedman’s observation as prices, especially the everyday ones, rise around us. In our view, we do not yet have “substantial inflation” nor is it a prospect. Prices are rising because demand for everything is rising. An example is U.S. auto sales by the Big Three, which are running at an annual rate of 5.45 million vehicles as of February 28, up from 3.35 million at the recession low in March 2009.The additional 2.1 million cars use a lot of steel, aluminum and rubber. While the Mid-East unrest is disrupting the oil supply, the real cause of higher prices is the economic demand from the emerging economies and the recovering developed nations.

What bothers investors is not knowing whether the Fed has the resolve and ability to reverse the massive injections of money aimed at stimulating banks to extend loans and revive employment. In our view, conflating this money with near-term inflation is misplaced. Accelerating, systemic inflation, however, will come if the Fed and its peers cannot—or choose not to—deliver on their frequent assurances that they have the tools, the will and the authority to take back the liquidity by selling the assets they have acquired. 

The so-called money multiplier tells the tale. This statistic measures the amount of money “created” when a bank makes a loan. Decades of data indicate that each dollar of bank reserves available to be lent becomes between $8 and $12 of loans.

Today, the multiplier hovers around $4 for every $1 lent. Should the multiplier return to the bottom of the long-term range, at an 8 to 1 ratio, the money in the economy would expand from around $9 trillion to $18 trillion—or by 100%! (CHARTS 2 & 3).

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1. Bloomberg.

Can productive capacity and employment expand this fast? Doubtful. Hence, it would be cynical, short-term, politically inspired folly for the Fed to allow money expansion to so sharply outstrip what the real economy can produce. The price would be steep, as it was 33 years ago. With the stakes so high, it seems improbable history will repeat while memories are vivid in policymakers’ minds.

Of course, these ideas seem distant and irrelevant when we are facing the gas pump or grocery checkout—in the U.S., in Delhi or in São Paulo. To us it feels like Friedman’s “substantial inflation” is here—especially where food accounts for a large share of price increases, as it does in the developing economies. Consider that in India food claims 47% of consumer prices vs. just 14% of consumer prices in the U.S.2

As they have in the past, rising food and fuel prices are likely to stimulate farmers to plant more, and to cause more remote and expensive oil reserves to become profitable and be brought to market. As supply rises, prices are likely to moderate. They will not, however, if the Fed reneges on its anti-inflation resolve.

What does not receive enough attention is how strong the recovery is. Corporate profits for firms in the S&P 500 have marched upward for six straight quarters from early 2009. Indeed, with the reports almost all in for the fourth quarter of 2010, corporate profits advanced 38% from the prior year.3 Importantly, corporate sales rose 7.9%.4 The expectations for further increases also remain strong (CHART 4).

With this growth in earnings, we believe the value of equities remains attractive at 13.6 times forward estimated earnings.3 This is well below the long-term average (CHART 5).

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2. Strategas Research Partners, 2/1/11.;  3.  BEA, NIPA;  4.  Bloomberg.

As always, the markets are sending many and often contradictory signals. As these remarks, however, suggest, the expansion’s underpinnings—earnings, ongoing fiscal and monetary stimulus, and the increasingly evident sustained growth in jobs, sales and global trade—support our confidence that the expansion will continue.

The U.S. trade data alone is stunning, with exports of goods up 41% to $163 billion in December compared to the April 2009 recession low, and imports of goods up 39.4% to $203.5 billion over the same period. While the trade deficit suggested by these figures commands most attention, the growth in both exports and imports is another measure of a recovery’s strength.

5. BEA, NIPA, U.S. International Trade in Goods and Services, Exports, Imports, and Balances.

We have stayed invested, positioning portfolios to have exposure to the rapidly growing wealth within emerging markets as well as rising earnings of U.S. corporations. Industrial companies—wherever located—that are manufacturing products that enable development of the emerging world and renovation of aging infrastructure in the U.S. continue to be especially attractive to us. We also have a favorable view toward companies providing basic inputs--energy, metals, chemicals and bulk transportation. Technology and communications are central to growth. In our view, another attractive group of companies are those that provide discretionary products, such as automobiles and luxury goods, to the newly wealthy.

Bonds continue to present increasing risk as interest rates rise, reflecting greater demand for loans along with inflation anxiety. We do not foresee loss from carefully selected fixed income positions, but we believe the opportunity for gain has shifted toward equities.

Lastly, if we are correct that earnings will continue to rise, dividends will as well, which adds to equities’ attractiveness. We are highly sensitive to the uncertainties presented by the rebellions in the Arab world, how much the market’s behavior hinges on the Fed’s firm but deft withdrawal of stimulus, and the critical need to have real, measurable progress toward reducing public deficits and curbing the growth of entitlement spending. The states have taken the lead. Will the federal government follow? The presidential election season starts all too soon, and if history is prologue we can expect little needed austerity until 2013.

Mackin Pulsifer
Vice Chairman and Chief Investment Officer


In response to the widely publicized negative media attention directed at municipal bonds, investor sentiment became less favorable toward the sector in early November 2010. This negative investor sentiment was illustrated by the tremendous and continuous weekly outflows experienced by municipal bond funds which began during this time.

This reduced investor demand caused prices of municipal bonds—particularly longer-term municipals—to drop, and yields rose nearly 1% from the lows reached in September 2010. In fact, valuations became attractive enough to entice non-traditional municipal buyers, including hedge funds and other institutional investors, to buy municipal bonds, causing yields to decline from their peak in mid-January. Supply was nearly halved versus the same period last year as some supply was brought forward into the fourth quarter of 2010 in advance of year-end tax legislation. This, combined with low seasonal issuance patterns, led to price stabilization.   

As protests against autocratic regimes spread across the Middle East and Northern Africa, concerns about the stability of the region, surging oil prices and continued access to roughly one-third of the world’s oil supply caused a renewed bout of risk aversion, and Treasury rates also retreated from their early quarter highs with the 10-year Treasury yield falling below 3.5%. The combination of these events slowed the pace of fixed income redemptions. Contrary to popular perception, by early March, yields on intermediate maturity, high-grade municipal bonds were lower than where they started the year.

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We believe core inflation in the U.S. bottomed during the third quarter of 2010 and will gradually move higher over the next 12 to 18 months. However, until excess slack in the labor markets has been absorbed through the creation of new jobs, it is our view that there is little likelihood that core inflation will move beyond the Federal Reserve’s preferred level of 2%. We anticipate a modest upward drift in inflation that will push fixed income rates moderately higher as we move forward throughout the year.

As the tug-of-war between global events and domestic fundamentals exerts its influence on market valuations, we expect a challenging and opportunity-filled year ahead for fixed income investors.

We are capitalizing on the low supply environment to position portfolios for a resumption of issuance, which we anticipate in the second quarter. The possibility exists for heightened volatility in the quarter ahead as many states grapple with their mid-year budget deadline. We continue with our defensive bias and are maintaining our focus on high-quality, short to intermediate maturities. This approach has helped mitigate volatility and preserve capital over the past two quarters, and we believe it will position portfolios to benefit from the opportunities ahead.

Ronald Sanchez, CFA
Director of Fixed Income Strategies




  • Our tactical allocation recommendation to equities remains overweight, with an emphasis on U.S. large-cap and U.S. small-cap stocks.
    • We believe the U.S. market may be in a sweet spot of rising earnings and sales, within a lower inflation climate relative to other markets.
  • We are more cautious on emerging markets and have reduced our tactical allocation recommendation to a neutral weighting.
    • As the global recovery broadens, we believe the growth differential between the developed economies and the emerging markets will continue to narrow.


  • Our ongoing strategy is primarily focused on preservation of principal and risk management, and we continue to maintain portfolios with below-market interest rate sensitivity.
  • In general, we expect opportunistic exposure to corporate bonds and high-yield bonds to benefit portfolios, even on an after-tax basis.
  • We have recommended that a portion of the municipal bond allocation be redeployed to U.S. government-guaranteed securities with maturities between two and five years, with an emphasis on mortgage securities.
  • In our view, select, short-intermediate term municipal bonds from jurisdictions we believe have lower exposure to budget issues will continue to present opportunities.


  • Our recommended cash allocation remains relatively low.
    • In spite of concerns over rising oil and commodities prices and how these factors will affect the markets, we believe overall market conditions argue for remaining invested at this time.

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Stephanie Luedke
Executive Vice President, Investment Management

Jonathan Hatch
Managing Director

Srivatsa (Sri) Kilambi
Vice President, Strategic Advisory Group

Wayne Sprague
Managing Director, Strategic Advisory Group


The right asset allocation can mean the difference between succeeding and failing to meet an investor’s goals. With the world’s markets becoming increasingly interconnected, investors are challenged with finding ways to adequately diversify their holdings. Our Fiduciary Trust Forum provides insights into our asset allocation approach and how we are managing client portfolios in light of increasing economic globalization.

Q:  How do you determine the firm’s long-term investment views? 

Stephanie: We have a formalized, disciplined process that includes research and analysis done by senior analysts in our Strategic Advisory Group as well as by some of the senior investment professionals across the firm, including our Chief Investment Officer and our Director of Fixed Income Strategies. Our purpose is to develop well-researched and tested asset allocation recommendations that our portfolio managers can use as a guide in constructing and managing our clients’ portfolios.

Wayne: We use history as a strong guide in determining our allocation views and then overlay our forward-looking assessment—characteristics that we think are going to be more critical in the future. This gives us the opportunity to combine historical observations with our expectations for the future.

Jonathan: Investors are bombarded by a constant stream of information and events that impact the markets. From a portfolio manager’s perspective, our Asset Allocation Committee’s views are very important in helping to filter out the chatter and provide a roadmap for client portfolios. Having this overall strategic plan in place keeps portfolios on course, especially through periods of higher volatility. 

Q:  What has caused your outlook to change over time?

Sri: Our strategic views are very long term in nature and we don’t typically make significant changes from year to year. That said, we review and retest our thesis on an annual basis to make sure that we are evolving our views appropriately over time.

Wayne: And our views have evolved. For example, years ago a U.S. investor’s portfolio was predominantly allocated to U.S. securities. Over the past couple of years, portfolio allocations have shifted toward a more balanced approach to U.S. and non-U.S. securities, particularly in equity segments where growth prospects outside the U.S. are compelling.  An equity portfolio at that time might have held 60% U.S. equities and 40% non-U.S equities. Today, we employ a more balanced weighting. We also further diversify non-U.S. investments into developed countries and emerging market exposures.

Jonathan: A global perspective is part of Fiduciary Trust’s history—we have been investing globally since the 1960s. What’s changed is that we are developing that approach even further to define these areas as dedicated asset classes. That is really the evolutionary step here. It is what may encourage us to look beyond the S&P 500 as a benchmark toward a reference index like the MSCI World Index to obtain a more global perspective.

Q: How do you predict future trends?

Sri: Our predictions of market trends are based on proprietary research that takes current and historical market themes and extrapolates them into the future. A great example of how this has played out is in our expectation of asset class correlation (the degree to which markets move in tandem).

Today’s 24-hour electronic trading capabilities and increasing economic globalization are enabling events like those transpiring in the Middle East to impact all markets in a more efficient fashion. To predict future correlation in a world that is becoming increasingly integrated, our approach applies greater weight to more recent data and less weight to older trends, allowing us to capture the dynamic nature of these increasing correlations across time.

Q: With asset class performance becoming increasingly correlated, are you changing the way you manage portfolios?

Jonathan: Across the board, asset classes have been adjusting more rapidly, especially in times of unrest. For example, during the 2008 economic downturn, it almost didn’t matter what investors owned since all asset classes declined simultaneously. An asset class such as small-cap equities in theory would not be materially impacted by a subprime housing crisis. But where events drag on the whole economy, asset classes can move in lockstep in a powerfully parallel direction.

Stephanie: We therefore believe that adding less-correlated asset classes can provide the best diversification benefits by reducing the overall volatility of a portfolio. Investors are now challenged with finding more asset classes that are less correlated. They can no longer rely as heavily on the plain-vanilla asset classes like U.S. small-cap versus U.S. large-cap to adequately diversify their portfolios, since the correlation has increased over time. We have therefore been looking outside of these traditional asset classes in areas such as commodities, inflation-protected instruments or hedge funds for some clients. Such investments behave differently across market conditions.

Wayne: It is important to note that we anticipate rising correlations within broad asset classes, but believe historical relationships across major asset segments will remain intact.  For example, while we believe correlations between U.S. stocks and non-U.S. stocks will increase, the less-correlated relationship between stocks and bonds should remain intact.

Q: How can portfolio managers build a less-correlated portfolio and still meet a client’s objectives?

Jonathan: Commodities are a great example of an asset class that we have used to achieve greater diversification. However, one of the issues with commodities in particular is that they don’t produce income, and often are not tax efficient.

To gain this exposure, we may select stocks in the materials sector of benchmark indices whose price movement is generally highly correlated with the price movement of the underling commodity. Select mining companies and chemical producers, such as fertilizer and crop nutrient providers, are among those that have these characteristics. If we are seeking energy commodity exposure, we look for producers, service companies and equipment providers in this area. In this way we can get representation of the asset class while being in a position to produce income or distributable returns. In the absence of using pure gold, silver or direct oil and gas plays, that is one of the ways that we have been expressing such alternative asset classes in portfolios.

Q: How do you determine the tactical allocation moves that you make on an ongoing basis?

Stephanie: We evaluate the market opportunities on an active basis and accordingly apply tactical tilts to our strategic recommendations. Our emerging market recommendation is a great example of a recent tactical shift. Over the past few years our tactical position has been overweight compared to our long-term strategic target because we viewed greater opportunity for growth in emerging markets during that time.

Today, we have retreated from an overweight position to a neutral weighting, meaning our tactical recommendation is on par with our strategic target. Our strategic view remains the same—and is even overweight compared to many of our peers—as we believe emerging markets will bring opportunity to our clients long term. However, in the short term our views have become more cautious, resulting in a neutral weighting.

Wayne: The background to this recent tactical shift is really threefold. One is the social unrest that is taking on more of a domino effect throughout the region. Second, rising interest rates across many Asian countries and even Brazil may have a negative effect on stocks. And third, as investors embrace the concept of a recovering U.S. economy, capital may flow back into U.S.-oriented themes and away from emerging markets.

Sri: In addition, the increasingly higher costs of food and energy—which are not a big component of inflation as measured here in the U.S.—are a very large and critical component of inflation measures outside the U.S. The rising food and energy costs outside the U.S. can impact the fiscal balance sheets of these governments as well, because some foreign governments subsidize those costs.

Q: How do portfolio managers implement asset allocation recommendations in a client’s portfolio? 

Stephanie: The portfolio manager’s job is to give each client the highest probability of achieving their objectives without sacrificing the characteristics that are especially important to the client. They take strategic and tactical recommendations into account, and also look to our investment committees, such as our Equity Strategy Group, for specific security guidance. The Equity Strategy Group researches the stocks that dovetail with the Asset Allocation Committee’s recommendations. Ultimately though, the client’s unique needs guide the final placement of a security in their portfolio.

Jonathan: I’ll give an example of how this works. One of the challenges that we have in client portfolios in general now with the extraordinarily low levels of interest rates is generating income yield in portfolios. If the asset allocation committee recommends that 10% of a particular portfolio be held in emerging markets, the portfolio manager’s challenge is to find vehicles that provide yield as well as emerging market exposure. We may, for example, not find that in Hong Kong-based or Shanghai-based companies, but may have to look to Brazil or others for individual securities that have yield characteristics that we like.

Q: There has been a lot of media attention on fixed income markets, given historically low rates and higher-than-usual volatility. How have your views changed?

Stephanie: Strategically over the long term, municipal bonds for U.S.-based taxable investors have been the best fixed income asset class and the most appropriate for our clients. Our long-term strategic fixed income asset allocation target is 100% U.S. municipal bonds.

There are periods of time during a variety of different market environments—such as the one we are in now—when fixed income sectors outside of municipals are quite attractive, even on an after-tax basis. We actively adjust our tactical allocation and utilize sectors of the broader fixed income market to reflect our current views; today we favor U.S. corporate bonds and high-yield bonds.

This communication is intended to provide general information. The information and opinions stated are as of March 15, 2011 unless otherwise indicated, and do not represent a complete analysis of every material fact concerning any industry, security or investment. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether information in this newsletter may be appropriate for you. IRS Circular 230 Notice: Pursuant to relevant U.S. Treasury regulations, we inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.

Get in Touch

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MackinPulsifer_3370.JPGMackin Pulsifer
Vice Chairman and
Chief Investment Officer

sluedkeweb.gifStephanie Luedke
Executive Vice President,
Investment Management

RonSanchez_2293_web.jpgRonald Sanchez, CFA
Director of
Fixed Income Strategies

JonathanHatch.gifJonathan Hatch
Managing Director

Kilambi_Sri.gifSrivasta (Sri) Kilambi
Vice President,
Strategic Advisory Group

Wayne Sprague.JPGWayne Sprague
Managing Director,
Strategic Advisory Group


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Q1 Perspective: Will Inflation Concerns Derail Growth?

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