Since the start of the year, markets have continued to shift from hope to growth, buoyed by economies reopening and the vaccine roll-out, extremely easy monetary policy and fiscal stimulus working its way through the economy, and improving consumer and business confidence.
However, the strength of the recovery and scale of the policy response has resulted in growing concerns about rising inflation expectations. This came to the fore in February, when we saw a sharp rise in bond yields on the back of growing inflation concerns.
The inflation debate and implications for interest rates is arguably now the central issue for investors and markets. It is generally understood that the supply shock from mandated COVID-19 lockdowns and subsequent sharp rebound in demand on the back of economies reopening and Government stimulus is a recipe for a pick-up in inflation.
The degree to which this is cyclical and temporary versus more structural and permanent is the question.
Inflation scare or regime change?
It is not unusual following an economic shock and recession to see an increase in inflation. The maths and year-on-year base effect alone tends to see inflation numbers print higher. This was the case following the global financial crisis when US consumer price index (CPI) rose close to 4%. However, it proved temporary and soon declined.
The Federal Reserve’s preferred inflation measure – the core personal consumption expenditure (PCE) inflation – hit a low of 0.9% year-on-year last April and was 1.4% year-on-year in February (see Chart 1). Most commentators now expect it will be above the 2% target in the April data, and potentially above 3%.
For the time being, both the Reserve Bank of Australia (RBA) and the Federal Reserve in the US (as well as other central banks) are maintaining the position that inflation will be transitory, resulting from a short-term rise in prices as economies reopen.
Their view is that the factors combining to push inflation up are temporary, including pent-up demand, an increase in household disposable income from enforced savings and government stimulus payments, disruptions to supply chains, and travel restrictions.
They have indicated that, considering these factors, they are prepared to allow the inflation to temporarily overshoot their official targets.
They believe that the current inflation rise is cyclical and temporary in nature and will retreat. But what if it isn’t cyclical? What if it is being driven by structural forces that are more permanent? It’s a question that is worth serious consideration.
There are several significant structural changes in play that could drive inflation up more permanently.
One key issue is that of political populism and financial inequality. Post-COVID, the debate around rising inequality in wealth is likely to continue dominating political and economic decision-making, perhaps even more than it did before. The unique and global nature of the pandemic has seen a radical and co-ordinated pivot by governments globally to fiscal politics. The risk as we see it now is that the moral and political hazard of withdrawing fiscal support may prove too much, and temporary government programs become more permanent, as has become the case with ultra-easy monetary policy in the wake of the Global Financial Crisis (GFC).
It is also important to recognise that the nature of COVID crisis is very different to the GFC and more cyclical recession events. This is an event-driven crisis resulting in a major supply side shock and Government spending response not seen since war time. The result has seen household savings increase to multi decade highs along with house prices. This is very different to the situation after the GFC when households were forced to deleverage on falling house prices.
We think it would also be a mistake to extrapolate the lack of inflation post-GFC to mean that inflation will remain low now, given the different dynamics at play.
Whether or not consumers spend this money, or continue to save, remains to be seen. The indications are that there will be a strong resurgence in spending, but the key question is whether this will be sustained – which is considered a necessary condition for a more persistent rise in prices and inflation.
The COVID-19 crisis has also seen a marked shift in politics and sentiment to decarbonisation and climate change. The transition to a lower carbon world is expected to be much more commodity-intensive than the digital technology transformation and capital light business models that have delivered the productivity gains of the last few decades. Technology is going to play a significant role, but decarbonisation is also going mean an increase in, for example, electric vehicles, which use for about four times more copper than a combustion engine. Likewise, wind turbines use between three to six tonnes of copper per megawatt. The impact of this on commodity prices is likely to be inflationary.
But whether these inflation pressures are structural in nature, or more temporary, remains hard to predict.
Certainly, the absence of inflation in developed markets over the last three decades suggests that longer-term inflation fears may be unwarranted, and the drivers of deflation remain strong, including extreme monetary policy, technology disruption and ageing population.
Overall, we believe that both the RBA and the Federal Reserve will continue with their view that tightening policy too early will adversely impact the goal of reaching their inflation targets.
The risk is that if things go too far, and the economy starts to overheat, then inflation could become more problematic than they expect.
This would have far more profound implications for markets and equity valuations and the extreme dispersion policy intervention has had on prices and returns between financial assets, which have soared, versus real economy assets like wages and commodity prices, which have stayed low (see Chart 2).
Our view is therefore that it is a good idea to take into account the risk of higher inflation, even if we think the inflation risk is moderate over the medium to longer term.
The first way we are doing this is to ensure that any quality companies that we hold have got robust growth characteristics and pricing power. This means that if inflation rises, they could pass on the cost and maintain margins.
The second step is to ensure exposure to quality cyclical companies that have leverage to the economic recovery. For instance, we think energy will benefit through this higher inflationary period, so we have exposure to some energy companies. We also think that inflation, resulting in higher rates, is good for the banks. There are still some headwinds for banks in terms of growth, but we believe that valuations already reflect that.
Thirdly, we’re cautious about longer duration assets that don’t have a margin of safety or a clear catalyst. And the final step is removing any companies that will struggle to recover from the COVID-19 crisis or lack pricing power.
Overall, we believe that the shift from ‘hope’ to ‘growth’ in investment markets is continuing. This has been evident in the strong earnings growth reported during the
February reporting season in Australia, as well as in the more recent US reporting season. We expect ongoing momentum will continue to be driven by the vaccine rollout and the rebound in consumer spending, as well as the recovery of business confidence.
Growing prospects of a strong global rebound and the unique nature of this crisis and policy response also brings with it the risk of rising inflation expectations, and arguably the biggest risk of a regime change in deflationary trends that have dominated markets for 30 years.
In light of all this, we think it seems prudent and good portfolio risk management to think about how to position the portfolio in the face of higher inflation risks.
Hamish Tadgell is portfolio manager at SG Hiscock & Company.