Investors Need to Decide Whether the Risk of Inflation Is Real

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Reprinted from the FT – 18/07/2020

Hedges find favour but previous predictions of price rises have been wide of the mark. One of the most divisive questions for today’s markets is whether inflation is finally making a comeback after a long absence. Some investors seem to think so. They are upping their exposure to inflation-linked bonds and gold in an attempt to protect their portfolios from the threat of a run-up in consumer prices within the next 12 to 18 months.

This week, demand for 30-year Tips — Treasury inflation-protected securities with returns adjusted with moves in consumer prices — proved so substantial that the yield plumbed new depths, sinking close to minus 0.29 per cent, according to Bloomberg data.

Meanwhile, money has started flowing back into funds investing in Tips, in contrast to the outflows seen in March and April this year. More than $5bn rushed into these funds in the week ending July 8. That came despite a recent stumble in core PCE, the US Federal Reserve’s favoured inflation measure, to 1.7 per cent, well below the central bank’s 2 per cent target.

Investors counting on a pick-up in inflation can point to the determination of central banks and governments that are working in unison to minimise financial market turmoil from Covid-19 and to sustain an economic rebound. Already, a recovery in global trade has lifted the price of industrial metals and oil.

Tellingly, iron ore — the steelmaking ingredient that is one bellwether of global growth — recently overtook gold in terms of performance this year. Much of this reflects a credit upswing in China that should, in theory, bolster the global economy and corporate profits outside of the US, particularly in Europe and emerging markets.

Another potential source of inflation would be a sustained decline in the US dollar. The greenback’s slide from its March highs has boosted commodities and emerging-market asset valuations through a reduction in global funding costs. It is not hard to imagine these trends gathering momentum. Governments around the world have turned on the spending taps and the willingness of central banks to step in and tighten policy is low.

In addition, rapid economic recovery still cannot be ruled out. Viewed in this light, one can understand why some investors think the risk of runaway inflation has risen. More rapid inflation and an upswing in economic activity would facilitate a broader rally in stocks, driving the performance of cyclical sectors and helping to rebalance stock markets that have become heavily weighted towards growth stocks in general and tech in particular. This would also clip Wall Street’s leadership over other equity markets.

Fund managers overwhelmingly agree that the tech trade is primed for a setback given its run of late, and US tech shares have fallen from their elevated perch this week. The catch in the inflation theory is that investors have been burnt in the past by expectations of price rises.

Following the global financial crisis of 2008-09, predictions that central bank bond-buying programmes would fuel hyperinflation proved to be very wide of the mark. Meantime, another possible scenario is that inflation could kick higher without the economic growth to go with it. Instead, the legacy of Covid-19, in terms of high structural unemployment and hefty debt loads — as well as higher taxes and a rising regulatory burden for companies — will suppress economies’ ability to grow.

Analysts at Bank of America have flagged that risk of so-called stagflation, which could entail a tougher time for fixed income and equities. Low fixed rates of interest provide scant protection against higher inflation, while debt-laden companies would be challenged by a combination of rising interest rates and lacklustre growth. That would provide another reason for the current push for inflation-protected bonds and gold. Already, equities have shown some signs of flagging, with a majority of key cyclical sectors stuck in negative territory this year and also over the past 12 months.

Industrials, financials, and energy notably lag broad benchmarks such as the MSCI World index, the Stoxx 600 and the S&P 500. True, there has been a substantial bounce from the lows in March for cyclical, but this illustrates just how cheap some of these companies were looking at the height of the pandemic shock. Beyond the competing scenarios of reflation and stagflation remains another outcome: more of the same, or an extended period of modest growth and inflation, accompanied by low bond yields and meagre rises in wages.

Sovereign bond yields sitting near their all-time lows are a sign that economic stagnation remains uppermost in the minds of many investors. Bond fund managers are still awaiting evidence that the historic expansion of money supply in recent months will at some point push up prices in the broader economy. Only then will they shift from the disinflationary stance that has held since the last financial crisis.