Should we fear post-pandemic inflation?
Yes, we should fear inflation
Bernd Meyer, head of multi-asset and chief investment strategist, Berenberg
After decades of falling inflation, it is likely to return in the coming years and investors need to consider the consequences for their portfolios. Market participants who believe that the inflationary pressure of a 2021 economic recovery will be temporary, neglecting that along with triggering a huge global economic policy response, Covid-19 has accelerated underlying changes to global demand and supply that will push prices higher over the coming decade. Various disinflationary trends of the past are reversing and becoming inflationary.
Core inflation should rise across the advanced world over the next two years as part of the cyclical recovery. Falling spare capacity will lift production costs while declining unemployment will lead to rising wages. Together, the ‘cost push’ from producers and the ‘demand pull’ from more consumer spending, including pent-up demand for many consumer services, will contribute to faster increases in consumer prices. In addition, in parts of Europe, inflation will jump in 2021 as the 2020 VAT cuts expire and higher carbon emission prices add to the Consumer Price Index. The input and output price indices of the US Purchasing Managers Index have already risen to their highest level over the past 10 years and the US inflation surprises index has risen to a 12-year high.
Once economies and labour markets have recovered the Covid-19 losses, global inflation will likely increase more meaningfully in 2022 and beyond. The deglobalisation of trade in goods (e.g. near-shoring, diversification of supply-chains, sustainability considerations, declining wage differences between EM and DM), increased fiscal activism, a stronger role for the state in many sectors of the economy and a more strategic (less efficiency-oriented) industrial policy suggest that underlying inflation will be higher than it was before the pandemic. The ageing of societies and the structural shift to labour intensive services in health care, nursing care and entertainment will add to that. However, the steadily progressing digitalisation will counterbalance these inflationary trends somewhat.
Financial markets are beginning to price in such trends. Long-term inflation expectations priced in bond markets have already risen to (Germany) or above (US) the pre-pandemic level and will probably increase further especially considering the more flexible handling of the inflation target announced by the US central bank. Against this backdrop, the development of interest rates and nominal bond yields poses the greatest risk to financial markets in the scenario of economic recovery. A modest rise in yields for bonds with longer duration can be expected, but will certainly not exceed the rise of inflation expectations. Negative real interest rates will prevail.
Central banks will probably try to keep interest rates very low for years to come, to keep financing conditions loose for the high levels of government debt. Thus, while central banks will do their bit to avoid a 2013-style taper tantrum when a sudden jump in benchmark rates triggered a market panic, sustained rises in benchmark rates could involve substantial losses for the holders of bonds while any sudden spikes in rates could lead to temporary pullbacks in global equity markets.
Investors must at least be prepared for volatility in bond yields. Equity markets would not be immune to this volatility, especially considering that the interest rate sensitivity of equity markets has increased substantially with the rising market share and valuation of growth style investments. Yield curves can be expected to steepen and the dollar is likely to remain weak in the medium term. However, increasingly negative real yields continue to support real assets such as commodities and equities. There is a risk that positive reflation hopes could give way to negative inflation fears over the course of 2021.
No, we should not fear inflation
Willem Sels, global CIO, HSBC Private Banking
Oil price base effects, rising food prices and increased fiscal spending have some investors wonder whether inflation and interest rates are on the way up, but we are less concerned. Both inflation and interest rates are low, mainly because of long-term structural forces, not short-term cyclical dynamics. While we may see continued bond market volatility in 2021, we do not foresee further upward drift in Treasury yields, and believe the low-for-much-longer environment should endure.
The oil price base effects are the result of the wild swings in oil prices last year, and are therefore largely backward-looking and temporary. The Federal Reserve (Fed) has noted that US Consumer Price Index (CPI) could briefly move above 2 per cent in the spring, but should come down again later. To set its policy, the Fed typically looks at core Personal Consumption Expenditures, which should move up less than CPI, and Fed funds rates should thus remain unchanged, anchoring the yield curve.
Fed chair Jerome Powell also said there could be a temporary burst in activity and upward price pressures when lockdowns are over, but sees this as a temporary phenomenon. We agree and believe such pricing pressures should be limited to areas of the economy where there are bottlenecks. In fact, in most areas of the economy, there is still a lot of spare capacity and low pricing power.
The state of the job market and the low level of global wage inflation keeps inflation down. Unemployment is high, and companies may be reluctant to re-hire until they have a clearer outlook on the economy and have repaired their balance sheets. While some commentators argue that deglobalisation in some areas of the manufacturing industry may boost inflation, this is more than compensated by the increased globalisation of labour markets. Competition between workers has arguably intensified further, as more jobs are moving online and their location becomes less important. What’s more, the structural trend towards automation, the decline of manufacturing and the growth of the gig economy further slow global wage growth.
Higher US fiscal spending should not be a major concern, either to the inflation hawks or to bond investors. First, although the Democrats have control of Congress, their majority is thin, somewhat limiting the scope for fiscal spending. Secondly, spending on handouts to households, states and small corporates principally compensates for their drop in income, and should therefore not cause overheating and inflation. Finally, there is no debt sustainability issue for the US.
So, while we fully expect some volatility in the CPI numbers this year, and bond yields may move up and down as investors wonder when the Fed will start to taper, structurally low inflation means that there is no urge for the Fed to normalise its policy quickly. Treasury yields should move in a sideways trading range, and Treasury inflation-protected securities are likely to underperform after the exaggerated pickup in inflation expectations. The search for yield should continue and we overweight crossover and EM bonds. This environment should also be positive for stocks, ease the concern over growth stocks, and prompt investors to become more selective in their value stock picks. From a currency perspective, the US dollar may continue to depreciate somewhat. It is too early to call for an end to the era of low bond yields and cheap money.
