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U.S. Not Wagging the Inflation Tail

Jason Stipp

Jason Stipp: I am Jason Stipp for Morningstar. With the threat of inflation and rising rates on the horizon, many investors are rightly worried about their fixed-income exposure and wondering what are their alternatives.

Here from Driehaus is K.C. Nelson. He's the manager of Driehaus Active Income and Driehaus Select Credit to talk a little bit about his take on the inflationary environment and how these alternative funds are looking to keep ahead of that.

Thanks for joining me, K.C.

K.C. Nelson: Thanks for having me, Jason.

Stipp: I want to start big and talk to you about the broad inflationary environment. It seems that we have seen inflation in the first half of 2011, yet there's some countervailing forces, high unemployment, it still feels like there's some slack in the economy, which would tend to keep some downward pressure on prices. As you're looking at the factors out there, what's your take on inflation? And do you have a different take on near-term versus longer term inflation?

Nelson: I think your assessment is correct. We're definitely seeing some inflationary pressure start to creep into the economy. In contrast, at this time last year when core inflation was running around 1% in terms of CPI, now we're through 2% for the first half of the year. PPI we've also seen a fair amount of increase in core inflation, that's now through 3%.

So inflationary pressures are starting to creep in. In terms of long-term versus short-term, I do think the long-term inflationary picture is much more difficult to judge, and where the true risk is for investors, which is one of the reasons why I think a lot of folks have cautioned investors away from going too far out the maturity schedule in terms of taking on fixed income risk.

The most important, I think, qualification or assessment for investors to make when thinking about inflation, though, that I've noticed over the past couple of years is that the U.S. historically has been able to control inflation to some extent on a global basis, because whenever our economy slumped, so did global commodities, and the economic engine of the world, so to speak, began to slow.

That has not necessarily been the case anymore. Emerging markets tend to be driving inflationary pressures. So, that presents a difficult problem to investors. We may no longer be the dog that wags the tail to inflation on a global basis, and I think that's what we've been seeing here for the first half of this year.

Stipp: So, even if our economy is just sort of hobbling along, we still could see higher prices because in other areas of the world, that demand for those products still continues to go up?

Nelson: That's correct. That brings an ugly world like stagflation to mind. I don't think we're going to see that, but it's certainly a risk. I think the most probable outcome is something quite similar to what we've gotten for the first half of this year, which is, we have fairly moderate growth of around 2% real GDP. And at the same time, we have again, as I'd mentioned, on CPI, you're looking at core inflation of 2.5-ish percent and headline inflation far in excess of that. So, for the typical U.S. consumer, it presents a pretty negative backdrop for the foreseeable future.

Stay tuned: Parts 2 and 3 of interview with Nelson will be released on Thursday and Friday, July 21-22.