It is said that nothing is certain in life except death and taxes. For all of us, an invisible tax on our savings that is everywhere and always present is the rate of inflation in our economy. This is because as the prices of goods and services rise, the purchasing power of our savings falls.
For investors, how inflation behaves is also an important phenomenon that is closely watched, given its role as a key driver of interest rates and prices of financial assets. In recent weeks, expectations of rising inflation by market participants have contributed to volatility in the bond and stock markets, especially for high growth stocks in the technology sector.
Looking ahead, where inflation is headed is a key question: If inflation does increase more quickly than anticipated, this will pressure central banks to reduce the degree of monetary stimulus and raise interest rates from currently very low levels, which is a key supportive factor for asset prices today.
One common but incomplete intuition is that inflation is expected to rise if the supply of money is significantly increased. This explains why fears of rising inflation tend to escalate in the aftermath of an economic crisis, because central banks would have printed a significant amount of money in response to cushion the impact of a recession.
For instance, investors can recall that alarm bells over potential inflation had emerged in 2010 to 2012, after the US Federal Reserve had dramatically eased monetary policy to combat the economic shock of the 2008 Global Financial Crisis (“GFC”). Those fears, however, eventually proved to be unfounded. In fact, by mid-2013, various measures of inflation in the United States – the world’s largest economy – had reached multi-decade lows.
Today, in a similar fashion, fears of inflation are rapidly coming to the forefront after an unprecedented degree of monetary easing by global central banks in response to the Covid-19 crisis. A large part of this alarm is attributed to recent data which shows that inflation is in fact creeping up from low levels. In the United States, the core consumer price index rose from 1.6% in March to 3.0% in April. In Singapore, the core inflation rate - which is the most favoured price measure of the Monetary Authority of Singapore – increased to 0.5% in March from 0.2% in the prior month.
Most policy makers, including the US Federal Reserve, believe that this bout of inflationary pressure will ultimately be transitory, and that inflation fears today, like in the 2010-2012 episode, will prove to be mostly unfounded.
This could well be the case. First, prices are surging because of temporary shortages due to the Covid-19 pandemic but this is expected to ease over time. Second, while labour scarcity is temporarily holding back production and driving price pressures, workers are expected to return as unemployment benefits expire, and as the rate of vaccination in the population increases to herd immunity levels. Finally, various powerful long-term structural forces, such as technological disruption and demographic trends, continue to exert downward pressure on prices.
That said, it is sensible for investors to hedge against the tail risk that inflationary pressures ahead might turn out to be more worrisome than policy makers anticipate.
One reason is that the pace of the economic recovery post the Covid-19 recession is expected to be significantly more feverish than that after the 2008-9 Great Financial Crisis (GFC) which was disrupted by the European sovereign debt crisis. This means that the demand-side forces driving price pressures could turn out to be higher than those experienced after the GFC.
Another reason is that the degree of monetary and fiscal stimulus employed by central banks and governments globally during the Covid-19 pandemic is several magnitudes more substantial than during the GFC. To illustrate this, the expansion of the US Federal Reserve’s balance sheet in 2020 in dollar terms was more than three times that in 2008, and in 2021 alone, the US government is proposing more than US$6 trillion of new stimulus measures, which would be unprecedented in post-World War 2 history.
Finally, because of the sustained lack of inflationary pressures over the last decade, investment portfolios have primarily focused on – and benefited from – trades that rode on deflationary, not inflationary, trends. For instance, bond prices have broadly appreciated as interest rates fell, while commodity indices generally showed lacklustre returns over this period.
As the risk of inflation comes into focus ahead, however, investor portfolios are likely to increasingly move to incorporate inflation hedges. This would benefit investments that tend to perform well during periods of rising inflation. This includes carefully selected stocks in the financials, commodities and energy sectors that enjoy attractive valuations and strong earnings profiles, and companies with strong pricing power with resilient profit margins when the cost of inputs rises.
This article was published in The Straits Times on May 22, 2021.
