Equity risk if inflation passes 4%

Inflation rising past 4% could ‘choke’ equities in the future, according to T. Rowe Price, with the asset class only likely to benefit temporarily.  

Inflation in Australia was currently 1.1% but in the United States, it was 5% in May which was the highest rate since August 2008 and fuelling concerns about a rising inflationary environment. It was also giving rise to the idea that the Federal Reserve would begin ‘tapering’ its bond purchases. 

There had been speculation that value and cyclical stocks would do well in this type of environment but Justin Thomson, head of international equity and chief investment officer-equity at T. Rowe Price, said this was only the case ‘up to a point’.  

“Stocks can do well with a modest uptick in inflation but not a significant one. Historically, periods of rising inflation have been relatively good for equities in aggregate but only up to a point. Once inflation gets beyond 3%-4%, it has tended to choke off returns,” Thomson said. 

“The received wisdom is that monetary authorities understand inflation and have the tool to deal with it. But I think we could see a structural shift that will lead to higher inflation rates over the longer term.” 

He said three factors were driving the move towards higher inflation: large US fiscal deficits which had been enlarged by the pandemic stimulus, retired baby boomers spending their savings and labour shortages pushing wages up, and a move towards higher tariffs and supply onshoring.  

“The optimistic case is that the acceleration is a transitory effect that will fade as supply bottlenecks are overcome and the surge in post-pandemic demand runs its course,” Thomson said.