Inflation – are you scared?

Inflation has gone from bogeyman to benign, but could that be about to change as economies revive?

  • Bond markets are starting to reflect higher inflation expectations with ‘breakeven’ rates rising
  • There has been a 25% increase over one year in the US money supply (M2) and the IMF is predicting a 5.5% rise in output for 2021
  • Can policymakers withdraw liquidity quickly enough should inflation start to rise?

Inflation has been in short supply in recent years – almost no central bank has hit its inflation targets and for most, the battle has been staving off deflation rather than keeping inflation in its box. However, inflation expectations are ticking higher – is there is a risk it could revive? What would be the consequences?

While CPI numbers remain reasonably low, bond markets are starting to reflect higher inflation expectations. ‘Breakeven’ rates (which reflect the difference between nominal and real interest rates) have been rising since the start of the year and the US treasury yield curve has steepened. There have been huge rises in the prices of some commodities – iron ore, for example, has doubled over the past year.

This is perhaps unsurprising given the amount of liquidity in the market and expectations of economic recovery. There has been a 25% increase over one year in the US money supply (M2), which has been directed towards household and corporate savings. Even though the world is still grappling with the virus, the IMF is predicting a 5.5% rise in output for 2021, more than compensating for the 3.5% lost in 2020. China, in particular, is showing signs of a strong revival.

The question remains whether policymakers can withdraw liquidity quickly enough should inflation start to rise. For the time being, central banks have made it clear that they will look through higher CPI numbers in pursuit of self-sustaining growth. Inflation figures are likely to look high, given the weak comparison number from 2020. Equally, there will be anomalies. The most recent CPI print from the Eurozone, for example, was inflated by the ending of a temporary German VAT cut. Recent rises in energy are also likely to have a short-term impact.  

Policymakers would also certainly welcome some rise in inflation. Western governments are weighed down with a heavy burden and some revival of inflation would devalue it. It would also show that countries are on the path to recovery and have dodged a multi-year deflationary spiral.

The problem comes if there is an inflation shock. If a sharp rise in inflation prompted a similarly sharp rise in interest rates, recession would be almost inevitable. Equally, consumers and corporates have become used to low interest rates. A 2% rise in mortgage rates, for example, could put a major dent in household spending and destroy any nascent recovery.

It is enough of a risk that investors need to consider it in their portfolios. Any rise in inflation expectations and therefore bond yields could tarnish the lustre of growth assets. Part of their appeal has been that in a low interest rate world, their long-term cash flows are particularly valuable. Given their lofty valuations, any shift in interest rate expectations could see investors look elsewhere.

In theory, cyclical companies should offer more protection against inflation. Commodities and the mining sector have historically performed well in an inflationary environment. Today, the metals sector has a considerable tailwind in the energy transition, which is likely to create significant demand for metals. There has been talk of a new ‘supercycle’ in metals, with demand for areas such as Nickel, aluminium and copper rising more than 10-fold.

Any revival in inflation also makes government bonds look extremely risky. With little income or capital growth on offer from developed government bonds and high grade corporate bonds, many investors are holding them for diversification. This could prove an expensive trade-off if inflation surges and yields rise.

The past year has seen growth assets surge, alongside government bonds. Investors that have not rebalanced may find themselves ill-prepared for an environment in which inflation is a greater risk. If this is the quiet before the storm, it may be an opportune moment to ensure investment portfolios are fit for the environment ahead as well as the one just gone.