Inflation could be on the way – will it last and what it could mean for your portfolio

More than a year into the pandemic and the global economy is showing signs of a swift rebound thanks in part to vaccine progress – both the development and the rollout. Recreational restrictions have been lifted in some states in the US and strict lockdown measures in the UK are being eased.

As the global economy recovers, it appears developed markets may encounter something it hasn’t seen for more than a decade: inflation. In fact, bond markets have already begun to price in inflation with long-dated government bond yields rising to multi-month highs – a bellwether for inflation expectations.

The anticipation of inflation comes after governments launched substantial fiscal stimulus to alleviate the economic impact on those most affected by the pandemic – vastly different from the monetary policy-dominated response to the 2008 financial crisis. Whether it was small business protection, unemployment benefits, direct payments or wage subsidies, governments have put money in people’s pockets to stave off a severe economic crisis.

Now, as society begins to resemble some form of normalcy, this fiscal stimulus could be released into the economy creating upward pressure on prices. And as this begins to unfold, one question investors face is whether the expected inflation is transitory, or persistent, and what it could mean for their portfolio.

The idea of transitory inflation is that as the economy opens up, the fiscal stimulus will create pent-up short-term spending in sectors that were suppressed during the pandemic. These could include entertainment, airfares, hotels and apparel, which regain some pricing power to make up for revenue lost during the pandemic.

Just how much pent-up demand could there be? Well, the US M2 money supply, which is the total measure of money that includes cash, checking deposits and other savings vehicles, increased from around US$15 trillion to nearly US$20 trillion in 2020 alone.

Another way to look at it is the savings rate. In the US, stay-at-home measures and stimulus saw the personal savings rate reach around 33% in April 2020 – the highest level on record. The most recent figures have it at 13.7%, still well above the long-term average. 

The argument that inflation will be transitory – or short-lived – is that once the pent-up demand has been exhausted and post-COVID spending abates, things such as supply chain efficiencies, capacity growth to meet the demand and competition will cause prices to ease.  

Furthermore, without significant wage increases, real income declines during these spikes in inflation, which leads to demand tapering off.

As just noted, without a significant improvement in the labour market – both the unemployment rate and wages – long-term above-normal household spending cannot continue, even though household finances are in good shape, as shown in the personal savings rate.

On the other hand, what if the labour market rebounds faster than expected and wages rise? This is the argument for long-lasting inflation. Simply put, a sharp rebound in labour markets would give employees the bargaining power, pushing wages up as employers have to compete for workers. This leads to persistent inflation as companies raise prices to maintain profit margins.

Elsewhere, the geopolitical landscape could impact inflation. Rising protectionism and re-shoring – where countries bring manufacturing and business operations back to their own shores – would come at the cost of cheap labour and input prices, which would push prices higher.

If we see persistent inflation, central banks could find themselves in a delicate situation. On one hand, the accommodative monetary policy since the 2008 financial crisis was an attempt to push inflation towards 3% and a strong economy.

On the other hand, if inflation was to overshoot the 3% level for a period of time, tightening of monetary policy to slow this inflation could push interest rates higher – a precarious scenario when countries and households hold record levels of debt that requires financing.

Inflation, if within a certain band, is generally considered a good thing. It signals there is strong demand for goods and services, a sign the economy is expanding.  

However, inflation can bring challenges to investing. In an inflationary environment, interest rates tend to rise, which pushes the price of bonds lower as debt obligations on the bonds increase. Furthermore, some equity sectors can be sensitive to rising rates; as the risk-free rate rises, it can be harder to justify some equity prices – often prevalent in the growth sector.

However, some sectors are traditionally attractive in this environment, namely value or cyclical stocks, which benefit when an economy is expanding. Banks for example can benefit from inflation and rising interest rates. They can take advantage of a steepening yield curve by borrowing at the short-end of the curve where interest rates are lower and lending out at the long-end, where interest rates are higher.

Given the dynamics of an inflationary environment – one we have not seen in the developed world in more than a decade – we believe that active management could not be more important. As an active manager, ANZ Investments have the tools to navigate what can be a tricky, yet rewarding investment environment.

Despite the uncertainty of a post-COVID environment, we approach our investing with a long-term focus and are confident we can deliver consistent returns to our investors over the long term.