The challenges of investing in an inflationary environment

Over the past three months, as the global economy has gradually reopened from the COVID-induced lockdown, one theme that has dominated headlines is the pickup in inflation.

Whether the inflation is transitory, meaning it will be short-lived, driven by price increases in industries that were suppressed during 2020, such as airfares, hotels and petrol prices, or long-lasting, meaning structural changes to the economy have taken place and we are in for a longer-than-expected period of higher prices, one thing recent data has shown us is that inflation – for now at least – is running at above-average levels.

In the US, economic data for the month of May 2021 showed CPI was running at a year-on-year rate of 5%, the fastest pace in more than a decade.

Source: US Bureau of Labor Statistics

And with inflation running at multi-year highs, investors face a challenge they have limited experience with. In fact, higher-than-expected inflation hasn’t been an issue for investors for decades.

On the face of it, it would seem faster-than-expected inflation – especially prolonged periods – is challenging for both bonds and equities. This is because as central banks raise interest rates to slow inflation, this reduces the relative attractiveness of bonds and equities versus investing in cash, all else being equal.

However, inflation doesn’t necessarily mean all equity sectors face headwinds. In fact, some have historically done well, or outperformed a relative benchmark, meaning that while the investing horizon may look challenging, it can bring opportunities.

Commodity-related companies often perform well in periods of inflation. During the first six months of 2021, the price of oil rose more than 30%, in US dollar terms. Over the same period, US year-on-year CPI rose from 1.4% to 5%. Moreover, energy has been the best-performing sector in the S&P 500 index over the first half of the year, returning more than 40%.

Elsewhere, traditional infrastructure assets, such as railroads, airports and utilities (water, gas, electrical), may have links to inflation through regulation or concession agreement contracts, which allow them to offset some risks associated with above-normal inflation. For example, several toll road operators in France have CPI-linked prices negotiated with the local government, meaning, if inflation rises they can increase toll prices.

For airports, many having pricing power to sustain margins through strategic positioning that can, or has already, limited competition.

And it’s not just investors that are faced with challenges in a rising inflation environment – central banks are also in the spotlight.

The debate between transitory and permanent inflation is the most pressing question central banks have been faced with for a long time. For now, most central banks have communicated that they believe the recent inflation to be – for the most part – transitory, and are comfortable with inflation running at above-target levels for some time.

However, should inflation persist, central banks may have to lift interest rates to curb inflation. That would bring its own challenges – one being government debt.

Since the financial crisis, governments have become heavily indebted through increasing fiscal stimulus to support the global economy. If central banks raise interest rates, they are increasing the borrowing costs on the trillions of dollars in government debt.

Furthermore, as interest rates have hovered at record-low levels, household debt has also risen, meaning rising interest rates could flow through to household expenses.

So, although the global economy appears to be in a relatively good place coming out of the pandemic, there are certainly challenges ahead, including rising inflation. Nevertheless, while investing in an inflationary environment can pose challenges, it also brings with it opportunities. ANZ’s active management approach and wide range of asset classes mean it has both the people and the tools to navigate this challenging investing environment.