Regime changes usually take a while to fully register among investors. The big talking point in markets at the moment surrounds the potential return of a more troublesome level of consumer price inflation and what protective action investors should take.
The underlying trend of inflation matters a great deal for financial markets and investor returns. The rise in both equity and bond prices in recent decades has occurred during a long period of subsiding inflation pressure and from recent efforts by central banks to arrest disinflationary shocks since the financial crisis.
A year after the global economy abruptly shut down, activity is duly picking up speed. The logical outcome has been a surge in readings of inflation and this week, a measure of US core prices recorded its largest annual gain since 2008, running at a pace of 4.2 per cent.
Core readings exclude food and energy prices and are deemed a smoother gauge of underlying inflation pressure, a point that many people outside finance find baffling when budgeting the cost of groceries and petrol.
So the significant jump in the core measure, and even accounting for the base effect of the pandemic’s brief deflationary shock a year ago, has understandably generated plenty of noise.
This will remain loud in the months ahead as activity recovers from lockdowns with a hefty tailwind of fiscal stimulus working its way through the broad economy.
But muddying the waters for investors is that the outlook for inflation is still difficult to judge at this stage.
“There is so much dislocation in the economy from the reopening and base effects from a year ago that it will take at least six to 12 months before we get a clear view of the underlying inflation trend,” said Jason Bloom, head of fixed income and alternatives ETF strategies at Invesco.
Investors who are now worried about an inflation shock face a dilemma. Some assets seen as traditional hedges against such a risk, like inflation-protected bonds and commodities, have already risen appreciably. Effectively a period of inflation running hot has been priced in to some degree.
And history does provide a cautionary note for those moving late to buy expensive inflation protection.
Past inflationary alarms, as economies recovered in the wake of the dotcom bust in the early 2000s and the financial crisis of 2008, proved false dawns. After a mercifully brief pandemic recession, the powerful and well entrenched disinflationary trends of ageing populations and falling costs associated with technological innovation are by no means in retreat.
For such reasons, a number of investors and the US Federal Reserve expect inflationary pressure this year will prove “transitory”. But stacked against deflationary forces is the immense scale of the monetary and fiscal stimulus of the past year.
The effects of monetary and fiscal stimulus means “inflation may settle into a pace of 2.5 per cent (annualised) and that would be different from the average of 1.5 per cent before the pandemic”, said Jason Pride, chief investment officer of private wealth at Glenmede Investment Management. “Inflation will be higher. At a dangerous level? No.”
In an environment of firmer growth and moderate inflation pressure, equities will benefit, led by companies that have earnings more influenced by the economic cycle. Investors also will seek companies that have the ability to pass on higher prices to customers in the near term and offset a squeeze on profit margins.
Still, a troublesome period of elevated inflation cannot be easily dismissed. The “transitory” argument could be challenged if economic growth continues to run hot into next year, accompanied by a trend of higher wages from companies finding it hard to attract workers.
Before reaching that point, expected inflation priced into the bond market may well push past the peaks of the past two decades and enter uncharted territory in the US and also for other developed markets in the UK and Europe.
Bond market forecasts of future inflation pressure over the next five to 10 years have already risen sharply in recent months. But the rebound is from a low level and for now, expected inflation is not far beyond the Fed’s long-term target of 2 per cent.
“It is the change in inflation expectations that drives asset returns,” said Nicholas Johnson, portfolio manager of commodities at Pimco. Assessing almost 50 years of data, a portfolio holding equities and bonds underperforms during bouts of elevated inflation, while real assets including inflation-linked bonds and commodities prosper, according to the asset manager.
“Most investors have not experienced a period where inflation surprised to the upside,” added Johnson. Clients are asking more questions about insulating their portfolios, but their present exposure to commodities and other assets show that in broad terms investors are “not paying much of an inflation premium”.
That can change and the prospect of inflation regime change remains a wild card for investors.