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Inflation and investments: why inflation matters now more than ever

Inflation is currently the most important indicator to monitor when it comes to financial markets. Now, more than ever, inflation matters. As investment managers, it matters because it determines which financial assets we might wish to hold, and those we should avoid. And it matters because central banks will be making key decisions, which will have a pronounced effect on all of our lives, based on their inflation forecasts. Inflation is not just a theoretical, abstract construct. It has real world implications which we need to analyse and consider.
Is inflation a problem?
Not at the moment. In fact, for the past 20 years in the US, the problem has rather been the lack of it. Current central bank orthodoxy is that inflation at or around 2% is an appropriate target. Too high an inflation rate – as per the 1970s – eats away at savings and runs the risk of spiralling ever higher. Inflation is pernicious; it can quickly soar out of control and cause considerable instability, both for society as a whole and in financial markets.
On the other hand, too little inflation, or outright deflation, brings with it a host of other problems; just consider Japan’s economic performance over the past 30-40 years.
A 2% inflation target is a comfortable middle-ground: a goldilocks level. Unfortunately, it hasn’t proved an easy target to meet. The preferred inflation measure of the US Federal Reserve (Fed) is the US Core Personal Consumption Expenditure (PCE) Index. For the past 20 years, the Fed has had great difficulty in maintaining inflation of 2%.
Have recent events altered the inflation dynamic?
The short answer is yes. The longer answer is still yes, but with the caveat that we’re not quite sure in which direction yet. And therein lies the crux of the problem. We can make convincing arguments for why inflation may become a serious problem. We can make an equally persuasive case that inflation rates might not markedly change and that in two or three years’ time we may look back at our inflationary concerns and wonder what all the fuss was about.
In this article we are restricting our comments to the US, but many of these arguments can be applied to the UK, Europe and parts of Asia.
Why might inflation become a serious problem?
The simple answer is because of money; more specifically, the trillions of dollars which are being poured into the US economy by the Fed and US Government. Even before President Biden’s latest US$1.9trn stimulus package, US$8.5trn had been either spent or made available in coronavirus-related support from monetary and fiscal policy. This equates to nearly 40% of the size of the entire economy. Government support in 2020 and 2021 far exceeds the action taken in response to 2008’s global financial crisis.
President Biden’s American Rescue Plan hands US$1,400 to nearly 80% of the US population. While these payments will be used for a variety of purposes, we expect significant spending and debt reduction to feature prominently. All this money will go somewhere, and it is reasonable to conclude that a massive surge in consumer demand will be a primary outcome. Economics 101 concludes that a response to substantially increased demand is higher prices.
Another way in which the impact can be evaluated is to look at the year-on-year percentage change in the M2 Money Supply. This is a measure of how much money is within the US economy – in this case in the form of cash, bank deposits and broad money aggregates – and is viewed as an indicator of future inflation. The chart speaks for itself.
Many households have built up significant savings during the pandemic; at the end of January 2021, household savings in the US stood at US$3.9trn and even a modest deployment of this sum implies a significant surge in demand.
There are many other arguments for higher inflation, the most significant of which is that the Fed is telling us that it is prepared and content for inflation to move higher and won’t proactively intervene to prevent this. The recent move to an average (rather than precise) inflation target means that periods where inflation has undershot its target must be compensated for by a period where inflation exceeds 2%. The Fed’s priorities have shifted from controlling inflation to maximising employment. When Paul Volcker became Fed Chair in 1979, he vowed to vanquish inflation – unemployment be damned! Now, Fed Chair Jerome Powell has turned this on its head.
Is higher inflation a foregone conclusion?
Yes and no. This year, inflation will inevitably be higher simply due to year-on-year base effects. In March 2020, a barrel of oil cost US$22. In February 2021, it stood at US$66. It’s a mathematical certainty that inflation will accelerate over the coming months.
However, it’s the outlook beyond the summer which is of most interest. The global economy will continue to recover in 2021, but some of the economic damage will take years to repair. If inflation was not a problem when the unemployment rate stood at 6.3%, why is it going to be a problem when the rate is likely to remain well above this level for quite some time?
Demographics, secular stagnation, technology and automation are all arguments put forward to suggest inflation will not be a problem in the future.
What will the actual outcome be?
Convincing arguments can be made for either scenario, but the fact is that no-one truly knows. However, even with this uncertainty, no problem is insurmountable; it’s simply a case of developing a strategy which can deal with the various potential outcomes. And that’s what we’re determined to achieve on behalf of our discretionary investment management clients.
Investment considerations for inflation protection
There is almost no financial environment where holding cash is likely to be the best investment option and cash is already being eroded in real terms. If inflation accelerates, policymakers are unlikely to react quickly and real yields (the difference between interest rates and inflation) will fall further. Realistically, the situation will get worse, not better.
It may be prudent to incorporate some form of inflation protection. This could be in the form of gold, US Treasury inflation-linked bonds or commodities. It’s also difficult to argue for the merits of holding low-yielding nominal bonds, particularly government issues. Fundamentally, they are not particularly attractive now, let alone if inflation accelerates.
Finally, the cyclical bull market in stocks is only likely to end when inflation moves to such a level that central banks are forced to raise interest rates. This is not a risk in the near term and equities are one of the better options for protecting against inflation in a low interest rate world. However, it may be appropriate to moderate exposure to growth stocks, such as technology, while increasing exposure to value areas, including financials.
The best decision in 2021 may be to hedge against the risk of higher inflation, while remaining exposed to assets which can continue to deliver attractive returns in a variety of investment environments. In this regard, equities remain the most attractive asset class.
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If you have any questions about the current environment or about your investments, please get in touch with us or email questions@canaccord.com.
Please remember, if you hold an account with Canaccord, you can check your portfolio value at any time, through Wealth Online or by getting in touch with your Investment Manager.
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Investment involves risk and you may not get back what you invest. It’s not suitable for everyone.
Investment involves risk and is not suitable for everyone.