Inflation – should you be scared? (and what you can do about it)

Policymakers have responded to the Covid-19 outbreak by spending: history suggests this should create inflation. Should investors be worried and how can they protect themselves?

It’s been a little while since investors have had to worry about inflation. After a brief, currency-related blip in 2017, inflation has been falling for the past three years and now sits closer to zero than at any almost any point in the last 25 years.

For many investors, this would suggest that their greater fear should be deflation. Certainly, by shuttering economic activity, the Covid-19 crisis has kept a lid on any inflationary pressures in the short-term. The last set of inflation statistics showed falling prices at restaurants and cafes, and for air fares and clothing. Plus some structural deflationary factors remain: cheaper goods from China, technical advances, high government and consumer debt. Since the Financial Crisis, policymakers have consistently worried about a ‘Japanification’ of the global economy, where structural deflation becomes embedded.

However, there are a number of factors that suggest inflation may yet re-emerge. It had been thought that quantitative easing might bring about higher inflation. It did, but only in asset prices. These price rises aren’t captured by official statistics.

The Covid-19 crisis has prompted governments across the world to take more direct action with vast stimulus programmes. Instead of an indirect mechanism, through the banking system, this money is likely to find its way directly into the hands of consumers. This may be through the ‘helicopter money’ approach of the US, paying cheques to every citizen, or through ‘eat out to help out’ and furlough schemes.

While the world is still struggling to deal with the restrictions imposed by the Covid-19 outbreak, these schemes are only likely to balance out the negative impact. However, should the impact of the virus be less than expected, they may prove inflationary. If a vaccine is found, the world may return to normal relatively quickly, without the vast job losses that had been anticipated. There may also be a significant release of pent-up demand.

This is not as unlikely as it sounds. There are currently seven viruses in stage 3 trials – where an average of 85% of vaccines proceed to approval. By these odds, five or six vaccines should get through.

Michael Lake, director for fixed income at Schroders, also believes that a reversal of globalisation may have an impact: “The reduction of globalisation (another longer-term structural theme), could be inherently inflationary and this process may also have been accelerated by Covid-19.

“One of the major consequences of globalisation in recent decades has been increasingly global supply networks and lower labour costs. A reversal of this trend (which was already in evidence prior to the pandemic) as a result of reduced global connectedness, through both global trade and a reversion to more localised labour forces, risks raising inflation due to limited competition.”

How do investors manage this in their portfolios? There is direct inflation targeting, such as inflation-linked bonds. These would do well in an environment of low rates and high inflation, which gives rise to strongly negative real interest rates. That said, investors need to ensure that higher inflation expectations are not fully reflected in prices. Gold also tends to do well at a time of higher inflation as it is considered a store of ‘real’ value.

Equities are a natural home for investors worried about inflation, but they would need to be the right kind of equities. Equities are only an inflation hedge if companies have sufficient pricing power to raise prices at a time of higher inflation and this isn’t an option open to all sectors of the economy. It would be a difficult environment for conventional bonds, as their fixed cash flows would lose purchasing power in a rising inflation environment.

For most, the key will be simply to retain growth assets in a portfolio. This is a generation of investors unused to dealing with the corroding effect of inflation in their portfolios. This may need to be front of mind if there is any unlocking of the global economy.