With a strong economic recovery and pretty loose monetary and fiscal policies, the question of a return of inflation is back in the spotlight.
Nadege Dufosse, global head of multi-asset at Candriam Asset Management, argues that in the short run there are many reasons for tensions to persist: higher commodity prices, surging shipping costs, bottlenecks in some industries (for semi-conductors in particular), depleted inventories, but also price increases in the service sector due to the reopening of economies.
All these factors have combined to push prices higher: producer prices as well as consumer prices have significantly accelerated in many countries.
In addition, PMI surveys are generally pointing to higher input prices, lengthening supplier delivery times, signalling inflationary pressures are likely to persist for some time.
Dufosse believes this phase could, however, reasonably be regarded as temporary (lasting a couple of more months) as supply will adjust to the reopening and inventories will be rebuilt.
“This might take a bit more time than sometimes expected as global supply chains disruptions have been significant. But most central banks are likely to remain patient before removing accommodation, looking through the transitory surge of prices as activity is gathering momentum”.
While Dufosse believes central banks will avoid premature tightening, she says the nervousness of market participants is understandable and inflation scares are likely to stay with us for some time. More so since some central banks might see some merit in having a bit higher inflation than before the pandemic.
“Didn’t the Federal Reserve in particular vow to tolerate a period of above-target price rises? All those betting on a permanent surge in inflation however are likely to be disappointed: if the economy were to get too hot, central banks are not short of tools to calm down tensions.”
Given Dufosse’s current expectations of mild inflation and higher but still low real interest rates, she remains overall overweight equities. “Contrary to bonds, equities tend to perform the best in a (mild) inflationary scenario. Even if equities P/E tends to deflate as long as rates increase, sensitivity to revisions in the growth momentum are even more important. Moreover, some corporates manage to pass on higher costs to consumers which limits the impact on earnings”.
On the opposite side, she favours shorter duration and an underweight in bonds in such an environment. “The returns offered by these long-dated securities become less attractive as they may no longer compensate for inflation.
Small and mid-cap opportunities
In the equity space, Candriam’s strategy is geared towards stocks leveraged to the recovery, a steepening of the yield curve and rising commodity prices. “More specifically, we are buying small and mid-caps in the US, the UK and Latin America. Further, we have a positive stance on US and EMU banks, which benefit the most from the expected yield curve steepening,” Dufosse explains .
Corne van Zeijl, economist at Actiam, is another who sees higher prices as a short rather than long-term factor.
“Given the fact that we see the actual price inflation largely as temporary, we expect European rates to be relatively stable over the coming year. We assume a small rise of the 10-year German sovereign yield as likely, but still consider 0.25% as the top of the 12-month range.
“Therefore, our fixed income positioning is actually focused on some spread carry trades (mainly in peripheral sovereigns and in corporate issuers). On top of this medium-term approach, we also use a tactical approach to add some short-term alpha based on market sentiment and cyclical developments.”
Willem Verhagen, senior economist, multi-asset at NN Investment Partners, agrees with Dufosse that an upside surprise in inflation has caused some understandable nervousness.
He says that the important question for investors is whether the increase in inflation will continue to feed on itself once the economy reaches a new relatively stable equilibrium. This, he suggests, will depend to a large extent on the behaviour of inflation expectations.
“If they remain well-anchored, inflation will almost automatically revert toward the target, which acts as a strong focal point for price- and wage-setting behaviour. Inflation expectations have generally been at the bottom of the Fed’s mandate consistent range; the question is what might cause them to persistently break out of this range on the upside.”
Economic history suggests that such a breakout could happen in response to a regime shift in which worker bargaining power increases and the government forces the central bank to keep sovereign borrowing cost low despite accelerating inflation.
“We could be at the beginning of such a regime shift with a somewhat bigger social tolerance for higher inflation,” Verhagen suggests. “However, if this shift is happening it is unlikely to make itself felt strongly in the next year or two. US president Joe Biden obviously respects the Fed’s independence and the Fed itself has made it clear it will not hesitate to step strongly on the monetary brakes if it believes inflation expectations are in danger of breaking out on the upside.”
Back into balance
Daniel Morris, chief market strategist, BNP Paribas Asset Management, takes a similar line to both Defosse and Verhagen.
“If prices are rising because of a temporary shortage in the supply of a good or service, or a temporary surge in demand, the increase in price is the normal way a market regulates itself in order to bring demand and supply back into balance.”
He makes the point that central banks focus on two other types of inflation: firstly, a broader increase in prices across many goods and services because an economy is growing more quickly than its potential (the output gap is positive); this is not obviously the case today, either in the US or Europe.
Secondly, ‘wage push’ inflation, when expectations of a persistent increase in prices leads workers to demand, and receive, an increase in wages.
That could further stimulate demand, leading to higher inflation, resulting in demands for an increase in wages to compensate. Again, this scenario does not seem to describe the current (or likely future) environment.
Consequently, Morris echoes the views of Defosse and Verhagen that central banks are unlikely to tighten policy urgently despite the near-term increase in inflation.
“Don’t forget that inflation has been below most central banks’ targets for years, so even with the short-term, above-target inflation rate, the level of prices today compared to where they would be if inflation had been at target, is still quite low.”
He concludes: “The current bout of inflation is only compensating for a small part of the shortfall since the global financial crisis.”