While global attention has rightly been focused on the coronavirus pandemic, we are beginning to see the light at the end of the tunnel as the vaccine rollout begins to gather pace. However, the re-opening of the economy raises the spectre that long dormant inflation will soon resurface. After over a decade of low inflation, we look at the reasons why inflation could potentially increase over the next 3-5 years and whether investors should be concerned about the prospect of a sudden rise in inflation.
Why are inflation expectations rising?
Inflation is a measure of how fast the prices of goods and services are rising. Very high or very low inflation are considered bad for the economy, so governments try to maintain inflation within a desirable band. Inflation expectations have risen sharply since the lows during the depths of the pandemic.
There are several reasons to explain this rise in inflation expectations. Firstly, the expansion of money supply has been extraordinary with the US witnessing the fastest growth rate in over 150 years1. To put this into context, it even surpasses the growth seen in the 1940s when the US was preparing for war. The reason for this massive expansion of money supply has been the record levels of government and central bank stimulus pursued by policy makers in the wake of the pandemic, which show no signs of abating anytime soon. Growth in money supply, all things being equal, typically leads to a rise in inflation as the money funnels its way into the real economy and leads to an increase in economic activity.
Furthermore, as more people are vaccinated and the economy begins to reopen, there is strong pent-up demand for goods and services from consumers as generous government support has allowed many to build up their savings and reduce household debt. As unemployment begins to fall and consumer confidence recovers, this pent-up demand should boost spending and feed into higher inflation. However, the pandemic has also destroyed capacity in some sectors of the economy, and thus a strong and sudden rise in demand from a re-opening economy could also lead to higher input prices as it can take some time to bring production back online. We have already seen this in the energy sector, with the price of brent crude oil rising past $70 for the first time since January last year2. Rising energy prices will increase the cost of production for goods and services, which inevitably feeds into higher prices for consumers.
Why should investors be worried?
A sudden rise in inflation due to the policy responses to COVID-19 is a key risk for any unprepared portfolio. Inflation can be good for holders of some assets, if their values are able to rise faster than the general level of inflation. However, it can be bad for assets where the returns tend to be fixed, e.g. bond/debt holders, as higher inflation erodes the value of those fixed income streams. As a result, portfolios with high levels of cash and fixed income bonds are particularly vulnerable to rising inflation, especially given how expensive these assets already are.
How can investors protect their portfolios?
Looking back at data over the last few decades, risk assets like company shares or REITs (Real Estate Investment Trusts) have tended to provide some protection when inflation is low but rising (a similar scenario to the one we are in today). Rental income from properties tends to be linked to inflation, while a rise in prices should correspond to a rise in corporate earnings and thus a boost to the company’s share price. However, this may not always be the case as rising input costs can eat into companies’ profit margins, making them less attractive to investors. Looking more globally, we find that the UK market has also shown a high positive correlation to higher US inflation expectations. More cautious investors have historically used gold as a hedge to protect against the threat of rising inflation, given its limited supply and historical significance as a store of value. Alternatively, inflation linked bonds are debt securities that have their income stream tied to inflation, and so while the income tends to be lower than traditional fixed income securities, it provides more protection from rising inflation.
- Refinitiv Datastream, St. Louis Fed/Smith & Williamson Investment Management LLP, Data as at 11/02/2021
- Refinitiv Datastream, ICE Brent Crude Futures/Smith & Williamson Investment Management LLP, Data as at 10/03/2021
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.
Investment does involve risk. The value of investments and the income from them can go down as well as up. The investor may not receive back, in total, the original amount invested. Past performance is not a guide to future performance. Rates of tax are those prevailing at the time and are subject to change without notice. Clients should always seek appropriate advice from their financial adviser before committing funds for investment. When investments are made in overseas securities, movements in exchange rates may have an effect on the value of that investment. The effect may be favourable or unfavourable.
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This article was previously published on Smith & Williamson prior to the launch of Evelyn Partners.