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Fear inflation? Investors should love it

In the wake of the Great Recession, a golden rule for financial markets emerged: Every few months, investors would inevitably find something new to freak out about.

The panic attacks came fast and furious in the recovery's early days. There was the United States' debt rating downgrade, the Taper Tantrum, the fears of a bank run in Cyprus. I spent Father's Day in 2012 holed up in a room at my parents' house, covering the results of a Greek election – the winner of which I can't even recall.

These days, the freak outs are less frequent, for good reason. Every major developed economy is growing again. And investors started appreciating that markets would stabilize after all the mini-attacks.

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But give humans enough rope and – well, they'll get anxious at the very least. After an incredible run, Canadian and U.S. stock markets have started swinging again. Our new fear is an old friend: Inflation.

For years, economists and central bankers have prayed that consumer prices would finally tick higher. Now that they are – on Wednesday, it was revealed they rose in January at an annual rate of 2.1 per cent in the United States – investors question whether this is welcome or not.

For anyone wondering: We should be happy and there is no reason to panic. Growing economies are good things.

The fear, it seems, is that inflation will eat into corporate profit. If a car manufacturer has to spend more money to buy the components used to make its vehicles, the company's profit will suffer (unless it charges consumers more).

Central banks also raise interest rates during inflationary periods, which boosts the discount rates used when modelling stock valuations. There is an inverse relationship between these rates and the stock market, meaning share prices should, theoretically, fall when the rates rise.

And higher interest rates are likely to hurt mortgage borrowing, which should slow housing starts and sales.

All legitimate concerns. But both Canada and the Unites States are so very far from fretful inflation levels. Actually, 2 per cent is what both the Bank of Canada and the Federal Reserve have been hoping for.

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Rising inflation also signals a stronger economy – which should result in more consumer spending. Since 1971, the S&P 500 has climbed, on average, about 20 per cent as rates rise, according to S&P Dow Jones Indices.

The root problem underlying the recent swings is that investors got complacent, especially in the United States, where the S&P 500 rose an incredible 19.4 per cent in 2017. When everything is going swimmingly, we tend to make stupid bets. Many humans just can't help themselves.

The bet that's taking the most heat now is one against volatility. The U.S. stock market had been so calm, for so long, that investors cooked up ways to make money off the tranquillity. They devised securities to bet for, or against, the CBOE Volatility Index, better known as the VIX; once markets started to swing last week, these products started to tank.

The issue turned cyclical. Falling stocks made markets inherently more volatile and that hurt these bets. Investors saw what happened to the obscure securities, panicked some more because they were weren't sure how many existed and then sold even more stocks.

The media, I must add, didn't help things either. We often amplify minor problems. Already we're back to over-analyzing every single economic data point – such as one month of U.S. inflation data.

"The events of last week are normal," David Sykes, head of active equities at TD Asset Management, said in an interview. "We've forgotten that."

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Because the mental scars from the financial crisis remain so fresh, investors are still prone to overreact. This time, there's arguably even more to it. We're deep into a bull run and below the surface, we have to wonder how must longer this euphoria will persist. Before last week's mini-crash, the S&P 500 averaged 12-per-cent returns since 2010.

To that end, investors can follow a simple rule, one spelled out by TD Asset Management head Bruce Cooper: "Don't gamble at this point in the cycle."

Using history as a guide, after nine years of strong stock markets and economic growth, a recession is more likely than not. Yet, it probably won't emerge because of sudden consumer price spikes. U.S. inflation has come in under 4 per cent since 1991.

If there's anything to worry about, it's the latest U.S. budget bill. In a research note last week, analysts at JP Morgan explained that "Trump's average budget deficits through 2020 would rival Obama's, but without the justification of a global financial crisis."

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