Don't ignore the looming inflation shock

The U.S. economy may finally be heating up — but not in a good way. For the first time in 15 years, demand in the world's largest economy is outpacing supply. The result could be an inflation shock that roils financial markets, according to Wells Capital Management Inc. "Regardless of its overall speed, an economic recovery is at risk of overheating whenever demand grows faster than supply," Jim Paulsen, the Minneapolis-based firm's chief investment strategist, told clients in a report this week. "Since most investors are not anticipating any serious overheating evidence, we are concerned a potential inflation scare, could produce a significant change in financial-markets pricing." By combining labor supply and the weakest productivity for any expansion since World War II, Mr. Paulsen reckons U.S. supply — or an economy's capacity to produce goods and services — has grown just 2% since the recession ended six years ago. That's so slow that it's even being surpassed by otherwise disappointing demand, something investors have failed to appreciate, he said. PRICE PRESSURE The risks comprise heightened wage and price inflation pressure, narrowing profit margins, higher borrowing costs and tighter Federal Reserve policy. With JPMorgan Chase & Co. also flagging weak supply as a concern, Mr. Paulsen acknowledges the signal is sometimes hard to read. Demand eclipsed supply in the first half of 1986, yet bond yields didn't bottom until March 1987 and the stock market didn't peak until five months later. In the early 1980s and early 1990s, rising demand also did little to upend stocks. The current disparity between demand and supply still has Mr. Paulsen warning of more market fluctuations to come. While he remains bullish on stocks, he favors diversifying toward foreign markets and recommends minimizing exposure toward bonds. "When an economic recovery transitions towards demand-led, good news typically becomes bad news for the financial markets," he said.