Whether it is a temporary rise or something more durable, recent data pointing to a sharp rise in consumer price inflation has seized attention of economists who for years have been used to a world of tame price pressures for many consumer goods and services. How does this influence asset allocation?
Inflation is haunting the financial markets again. No longer just a memory of the 70s and 80s in developed countries, consumer price inflation appears to be gaining ground. Of course, the rise in real asset prices after the massive central bank money printing post-2008/09 was a form of inflation. But prices paid at the shops appeared – at least most of the time – to have been relatively well behaved. Cheap goods imported from China and other parts of the world, coupled with the deflationary impact of technology and globalisation, kept a lid on matters.
But the years of tame CPI may be over. The disruption caused by lockdowns, and the further heavy public spending to handle the results, appears to have reignited the CPI. UK data last week for April showed that consumer price inflation rose by 1.5 per cent in the 12 months to April 2021, up from its 0.7 per cent growth rate to March; on a monthly basis, CPI rose by 0.6 per cent in April 2021, following a 0.3 per cent increase in March 2021. The figures are a way off from the double-digit numbers of 40-plus years ago, however.
Other numbers from the US have also pointed towards rising price pressures, of course. The US CPI jumped by 4.2 per cent in April compared with the level one year ago. This is the highest consumer inflation rate since 2008.
What advice should wealth managers give clients about inflation? How should HNW individuals hedge against it, and what asset allocation ideas make sense? Over the decades, standard responses have been to hold more gold, to put money into certain equities – which tend to (mostly) outperform bonds in an inflationary environment, and other hard assets such as fine art.
At some point the period of ultra-low/zero interest rates will come to an end. A form of “financial repression” - forcing people to save via equities instead of cash – can over time erode capital and distort economies. As or when interest rates rise, some of the yield-chasing behaviour of wealth management clients will have to adjust. A period of very low borrowing costs has been associated with a boom in private market investments such as private equity. How might these areas be affected when rates go up?
Here are some reactions to the figures last week. We intend to keep monitoring this emerging macro-economic story in the weeks ahead. To comment, email the editors at firstname.lastname@example.org and email@example.com
Royal Bank of Canada
We think much of the inflation spike is a short-term phenomenon. The annual inflation rate plunged to almost zero per cent at this time last year when the economy was shut down, and has rebounded sharply this year as businesses have reopened. Once we are past the April, May, and June period when prices last year were falling, the year-over-year comparisons should be less extreme. The question of how long “transitory” inflation will last is more difficult to gauge. The longer it lingers, the greater the risk that the Federal Reserve will shift away from its uber-accommodative monetary policies. We think this will take some quarters to convincingly sort out. This could keep equity market volatility and pullback risks elevated for the time being.
But the challenge for the overall US equity market is that the inflation-vulnerable and valuation-stretched tech sector represents a much bigger share of the market than it used to: 26 per cent of the S&P 500 today versus 17 per cent in 2010. As long as inflation jitters are front and centre, institutional investors may be inclined to ratchet down their tech exposure, at least temporarily. To us, this means more adjustment time for the market as a whole, which could include additional volatility and rotation between sectors.
Anthony Willis, investment manager in the Multi-Manager
People team at BMO Global Asset Management
Globally, we have seen plenty of evidence of inflation (not least in asset prices) but also in the real economy as evidenced by the US CPI numbers, the Chinese PPI data and the comments in the PMI surveys. We are in a period where financial markets are going to be regularly challenged between focusing on the positives of stimulus and strong economic growth as economies rebound, and the consequences of that economic rebound for inflation and potentially interest rates.
The central bankers have continued to push back on the potential for rate hikes, with various members of the Federal Reserve reiterating their expectation that higher levels of inflation were transitory and would ease back towards their 2 per cent target later in the year. Fed Vice Chair Richard Clarida said he was surprised by the US CPI reading but that he expects inflation “to return to or perhaps somewhat above our 2 per cent longer-run goal in 2022 and 2023” with this outcome “entirely consistent” with the Fed’s policy framework. His colleague Raphael Bostic said he was “expecting a lot of volatility at least through September” on inflation readings as transitory and base effects work through the data.
The US Federal Reserve will likely stick to their “transitory” narrative for several more months, but a continuation of the elevated data will likely continue to see financial markets reacting with volatility and testing the Fed’s resolve. The sensitivity of financial markets to rate moves was highlighted by the brief sell off last week after former Fed Chair and current US Treasury Secretary Janet Yellen said “it may be that interest rates will have to rise somewhat to make sure our economy doesn’t overheat”. Yellen later clarified her comments to emphasise that she was not predicting or recommending that rates increase, nor is she expecting inflation to be a problem. All the same, the market reaction highlighted the sensitivity of risk assets to comments on rates and inflation; something we will likely see repeated many times over the coming months.
Hinesh Patel, portfolio manager at Quilter Investors, and
Richard Carter, head of fixed interest research at Quilter
Patel: While much of this spike in inflation is due to the easing of restrictions and rising oil prices as demand is switched back on, this is ultimately bad inflation. Price rises are squeezing households but where it goes from here is difficult to tell. The data is noisy and will be all over the place or at elevated levels for months to come. As such, the Bank of England will not be compelled to act until it is sure a higher level of inflation is becoming sustained.
It is going to be difficult to tell when the BoE will buckle and reduce its stimulus and remove the quantitative easing that markets have become so addicted to. Investors will need to watch their moves and messaging carefully to help them work out how markets might respond. But investors need to look through the inflation numbers and assess the quality of businesses and their underlying models before investing in them. Those built on strong foundations, which have built up competitive positions will be the ones that will succeed in a robust inflationary environment.
Carter: “Despite the doubling of the inflation print in April, the Bank of England won’t be too concerned, yet. A significant part of the increase in inflation is due to the base effects versus last year when we went into lockdown and energy and petrol prices fell considerably. The BoE will expect this bout of price increases to be transitionary, and one that will likely resolve itself over the next six months as the economy re-opens.
The risk, however, is that higher inflation expectations become ingrained among consumers and producers and we start to see wages increasing substantially as well. At that point, it is harder to argue that the inflation is transitionary and the BoE would have to react. As always, investors should have one eye on inflation risks and hold some sensible hedges as part of their diversified portfolio.
Guy Foster, chief strategist at wealth manager, Brewin
Considering the implications for policy, rising oil prices have driven inflation higher. Future months will see some reversal of previous price cuts, but there remain few sources of enduring price increases for the Bank of England to fret over. In contrast with the rest of the world, the absence of the big giveaway stimulus seen in the UK, and the cautious approach to reopening the economy due to the Indian COVID variant, mean inflation will remain weaker than in the US.