It has been one of the main discussion points of the past three years, five years and even decades in the case of Japan: will inflation return? Low prices and ultra-low rates must surely end at some point; or maybe not... We are amid a pandemic and going through a period of depressed economic activity, so why would inflation even register on investors’ radars? As an asset allocator, it is imperative we consider what might happen to inflation and inflation expectations in the coming years in order to effectively build robust portfolios for our clients.
Most major economies collapsed in the second quarter of this year. However, we have seen a strong pickup in activity in the third quarter, due to the easing of lockdowns, while the intervention measures taken by governments and central banks globally to prevent a massive deflationary shock have gone a long way to replace the loss of income for businesses and individuals. With no clear end to the pandemic in sight, inflation is likely to be subdued in the near term, but further out is it plausible to expect it to pick-up?
In late August the Fed announced changes to its long-term monetary policy strategy. Among other things, they announced an average target level of inflation of 2% over the business cycle. This means the Fed will be more tolerant of deviations around the 2% number in the short term, and so there is some scope to overshoot which could potentially lead to a bias towards, and tolerance of, higher inflation.
For inflation to undershoot we would need to see more restrictive monetary policy sooner should business activity accelerate. This outcome would be less popular in the post COVID environment and higher rates would be damaging for corporates and the more highly indebted governments relying on Dollar funding markets. On the other hand, generating an overshoot requires rates to be kept low, whilst enabling unemployment to fall back to the pre COVID low levels. This is a more popular policy option but one which could potentially result in structurally higher inflation. Policymakers globally seem to be more tolerant of an inflationary response to this crisis, and of course that would help to debase the huge amount of debt governments have taken on in recent years. It does, however, limit their ability to respond to future slowdowns in growth if rates have not normalised to higher levels as business activity accelerates; a trap in which Europe is currently caught.
Both supply and demand factors may drive potentially higher inflation post COVID. The supply side may be constrained as businesses need to build local supply chains which pushes up costs, while on the demand side there should be positive effects from the increased fiscal response to this crisis.
The counter argument is that structurally disinflationary forces such as demographic and technological advances are still present and as a result could serve to put a cap on inflation. If the growth trajectory post COVID surprises to the downside, then inflation is likely to stay under the radar. Finally, any shift towards austerity would be a risk, albeit one that looks unlikely at this stage.
If inflation were to materialise, albeit only moderately higher, we would expect nominal bonds to struggle whilst equities to a certain degree will be able to pass on some of their rising input costs in the form of higher prices at the till. Cash and shorter duration assets should fare better but given the negative real yields on offer, the returns are less exciting. Commodities should do well and potentially emerging markets equity as these firms are used to operating in higher inflationary environment. Real assets and inflation linked bonds should be considered in such environment.
It is difficult to anticipate the inflationary trajectory, so at Momentum we believe in smart diversification and robust portfolio construction, in order to maximise our chances of delivering on the outcome. We aim to avoid our portfolios becoming exposed to any one scenario by allocating investments that can benefit incrementally from both higher inflation and a disinflationary environment. At the margin, the risk today of higher than expected inflation in the future has increased and as a result we took the opportunity over the summer, while prices remained somewhat depressed, to add to our inflation linked bonds, funding largely from their increasingly asymmetric nominal counterparts.