Inflation Doesn’t Seem Ready for Liftoff

Inflation Rate 2

The inflation rate should be an important consideration for investors. It not only affects the price of many investments—particularly those such as bonds which provide fixed periodic payments—but also how much money you need to reach your financial goals. But for all its importance the inflation rate hasn’t moved dramatically in recent years, and it doesn’t seem likely to start doing so any time soon.

The most commonly used measure of the inflation rate, the Consumer Price Index, was a measly 0.1% in the year through June. That’s far below the Federal Reserve’s target rate of 2% (the Fed technically uses a different measure of inflation, but their measure isn’t much higher). Part of the reason for the low inflation rate has been the plunge in the oil price, which has fallen by about 50% during the past year. But even the inflation rate based on the “core” Consumer Price Index, which excludes food and energy prices and therefore tends to bounce around less, is only 1.8%. It hasn’t touched 2% since early 2013, and it hasn’t touched 3% in almost 20 years.

When will this long period of low inflation end? To gauge financial markets’ expectations about what the inflation rate will be in the future, economists often use “breakeven rates,” which compare regular bonds to inflation-linked bonds. These currently suggest that the inflation rate will remain low, averaging less than 2% per year over the next 10 years.

Such numbers won’t necessarily prove correct, and investors who are concerned about a sudden surge in the inflation rate could use the current period of sanguine expectations to cheaply buy protection against higher inflation (for example with inflation-linked bonds). Yet there are good reasons to think that the inflation rate will remain subdued. Janet Yellen, the Fed chairwoman, recently said that the Fed remains on track to raise interest rates this year. If the Fed starts raising interest rates even as global economic growth continues to slow, the inflation rate may go down rather than up.

What the Changes to Your Vanguard EM Fund Mean

China Performance

Vanguard recently announced changes in the investments that some of its funds will hold. Perhaps the most significant of these changes are the ones that affect your Vanguard emerging markets index fund. The fund will add both exposure to smaller companies and exposure to Chinese companies whose shares are listed on stock exchanges in mainland China.

Including smaller companies is a change that Vanguard is making in many of its international funds. The stated reasons for the switch are to make investors’ exposures more in line with the overall market and to increase the diversification of their funds’ investments. These reasons make sense, since when you buy an index fund tracking the performance of a particular market, you generally expect it to track as much of that market as possible.

Stocks of smaller companies tend to be more volatile than stocks of larger companies, and they can also be affected by different economic factors. In emerging markets, for example, companies in the energy, communications, and financials sectors are a much smaller portion of the market among small companies than large ones.

The change to include Chinese stocks listed on stock exchanges in mainland China (often called “A-shares” as opposed to the “H-shares” of Chinese companies listed in Hong Kong) may be even more interesting given what’s happened in Chinese markets recently. As the graph above shows, starting in May the performance of the A-shares dramatically diverged from the H-shares. The A-shares soared until the middle of June and then plunged while the H-shares gradually declined.

Part of the divergence is caused by the companies listed in mainland China often not being the same as the companies listed in Hong Kong. But even A-shares and H-shares of the same company can behave very differently. A-shares have tended to be more volatile than the H-shares, and the disparities have increased in the past year.

According to Morningstar the small company change and the China change will combined affect only about 15% of Vanguard’s emerging markets fund, so they shouldn’t substantially alter the fund’s performance. Most of the fund will still be invested in larger companies, and Chinese companies listed in Hong Kong will still be a much larger portion of the fund than Chinese companies listed in mainland China. The only difference investors may notice is that by the time Vanguard finishes implementing the changes (which will be sometime next year), the fund will be slightly more diversified and possibly slightly more volatile.

Greece Isn’t the Only Political Risk

Europe Vote

Following the “no” vote in Greece’s national referendum on whether to accept the bailout terms proposed by its European creditors, the two sides continue to struggle to reach an agreement that would keep the country in the euro zone. For investors, the Greek crisis highlights the importance of “political risk,” the idea that the value of your investments can be hurt by political factors in addition to purely economic or financial ones.

In the case of Greece, the political risk for most investors should be fairly small. As we’ve noted in the past, Greece’s economy makes up less than one third of one percent of the global economy, and the size of its stock market is negligible compared to the global market. But the Greek crisis has the potential to exacerbate other political risks in Europe that could have a larger effect.

One is the possibility that—like the Syriza party in Greece—anti-establishment political parties could come to power elsewhere in Europe and cause further political and economic fragmentation of the continent. Such parties have even gained popularity in some of the largest European countries. In France, which makes up over 3% of the global stock market, the National Front party has made gains in recent years. In Spain, which makes up over 1% of the global stock market, the Podemos party is vying to win the national election that will be held later this year.

Another risk is that the United Kingdom (which has its own currency and therefore isn’t a part of the euro zone) will leave the European Union. The country’s prime minister, David Cameron, has pledged to hold a national referendum on whether the country should leave the EU. Leaving a political group such as the EU likely wouldn’t cause as much financial upheaval as a country leaving a currency union such as the euro zone, but it could harm many British companies.

The outcome of Greece’s current crisis will affect these other political risks. The disorderly financial collapse that Greece has suffered in recent weeks has probably made it less likely that other struggling countries will risk leaving the euro zone by trying to extract more favorable terms from their creditors. If Greece leaves the euro zone and its economy recovers, however, other countries may view a euro zone exit as a more enticing possibility. Furthermore, a breakup of the euro zone could make it more likely that the UK votes to leave the EU. The political risk from Europe is far from over.