As concerns rise about a global economic slowdown, investors may be tempted to push aside worries about inflation. In June, the US Federal Reserve’s (Fed) preferred measure of inflation, the core personal consumption expenditure (PCE) price index, rose only 1.6% year-over-year, well below the central bank’s 2.0% target. This extended a long-running pattern of subdued inflation in the US, which the Fed has been unable to change despite years of quantitative easing.

But we believe the headline numbers belie a growing number of underlying inflationary risks. For one, after years of quantitative easing, US money supply has multiplied dramatically. Until recently, these ‘excess reserves’ were held in deposit at the Fed, minimising the velocity of money, or the speed at which currency circulates through the economy – a key contributor to inflation, along with the absolute amount of money available.

Today, however, those reserves are moving off the Fed’s balance sheet and back into the economy at the same time that the central bank is cutting rates. In other words, the cost of credit is declining, which could lead to an uptick in transactions and a spike in inflation – the kind that can eventually kill equity rallies due to subsequent Fed tightening.

Source: Bloomberg, as at 29 March 2019 (velocity) and 28 June 2019 (excess reserves)

Meanwhile, an additional US$300 billion in Chinese goods imported into the US could be hit with 10% tariffs before year-end. The new tariffs would mostly affect consumer goods, where inflation is already percolating. Recent analysis, for example, shows that the average trip to a leading US retailer costs 5% more today than it did a year ago. July US retail spending numbers were very strong, as were unit labour costs – a consumer making more money and willing to spend is likely to bring on inflation. We worry that such anecdotal evidence is appearing in other sectors, but will only make its way into official metrics once an acceleration in prices takes hold.

For investors, we think it is important to carefully monitor price changes while also building a diversified portfolio. Among equities, for example, valuation becomes key. Options prices are indicating that non-US developed market equities, particularly in Asia Pacific are looking relatively attractive. Within fixed income, we think investors should focus on duration. The dovish stance taken by many central banks globally should put downward pressure on yields and drive up bond prices. We are also considering the potential in gold. The commodity has experienced a sharp rally in recent months, but holding gold could help to reduce the potential downside of an inflationary shock.