What We Talk About When We Talk About Inflation
Inflation is the topic of the moment. Some cynics argue it is only such a big deal because market commentators, fund managers and journalists have made it so. However, it is my opinion there is quite a lot of interest out there in the financial markets for all the right reasons. Evidence that the current preoccupation with inflation does not just come from journalists appears in the latest monthly Fund Managers Survey from Bank of America Securities Inc. (BofA) stating there is a ‘belief’ an inflationary boom is at its highest since the survey started in 2008.
For the time being, hopes are still pinned on a combination of higher inflation and growth, which is infinitely preferable to stagflation. Rising prices would create new challenges for money managers, but economic expansion would ensure they are not insuperable.
However, there is an important sign of a shift in perceptions. BofA (and others) regularly ask fund managers what they perceive to be the greatest ‘tail risk’ for the money they manage. For most of last year, the pandemic was the biggest concern. By March 2021, this had moved on to fear the Federal Reserve (US central bank) would try to tighten monetary policy too early, triggering a swift rise in interest rates that would see a large hurtful fall in stock markets. One only has to look back to 2013 when this actually occurred! Now, according to the reports from BofA, the greatest tail risk is that the Fed, and other central banks, might move too late, not too early, and fail to stop inflation from taking hold.
Inflation itself, then, really is beginning to create some concerns but is there genuine evidence of a clear and present danger? Commodity price increases are widely cited as one of the clearest signs of inflationary pressure, but they are also widely dismissed as a symptom of temporary or ‘transitory’ bottlenecks in supply as the economy returns to full strength after the pandemic. Furthermore, there are very low base effects when making comparisons with 12 months ago, which is why the year-on-year rise in the highly regarded Bloomberg’s Broad Commodities Index is at its highest in many decades.
Commodities that have created the most excitement among investors are those tied to the big macro themes. People want to invest in strength in construction (steel, aluminium, timber etc) and manufacturing (particularly, lithium and cobalt). Industrial metals, such as copper, have also been aided by both effects.
Commodities are very responsive to the effects of demand and supply, but also to the perception they are an inflation hedge. Oil futures are often used by traders of Treasury inflation-protected securities (TIPS), to offset risks, so they become directly linked to perceptions of overall inflation. That means commodity prices are not so much evidence there really is inflation out there in the real world, as yet more evidence that traders think inflation is coming!
However, commodity prices have been rising because investors are ploughing money in as an inflation hedge. If the Fed and other central banks take a more ‘hawkish’ stance, those trades could easily unwind. Likewise, the Chinese government could try to squash the commodity boom by moving more aggressively to cool the economy. Beyond that, the rise of the electric vehicle does raise the possibility the materials we most want over the next few years will have to rise in price. The boom in green technologies is great for metals like copper, aluminum, cobalt and lithium, while it also prompts bearishness about oil in the medium-term, although so far that bearishness is mostly expressed in the price of stocks in oil companies, rather than in the price of the commodity itself.
When risk increases, investors dive for the cover of Treasuries, Gilts and Government Bonds and that is true even if these assets are the source of the increasing risk and this process could place a limit on the chance of a ‘true tantrum’. However, it might not work that way again, as investors are tending to jettison the traditional notion of a portfolio of 60% stocks and 40% bonds, on the theory both could do badly if inflation returns.
It is also not clear inflation is such a bad thing, given the weight of outstanding debt in the economy. It is arguably the least painful, and also the most politically palatable, way to clamber out from under a huge debt burden. Which is the more pernicious risk, inflation that’s too low or too high? Very high inflation would puncture valuations in a global bond market (the value of which exceeds $128 trillion). Relatively stagnant prices would leave companies and countries saddled with record amounts of debt, unable to grow (or inflate) their way out of it.
If bond prices were to shoot higher, then there would be a risk of an equity selloff. The rate at which yields rise can be as dangerous as the level they reach. A swift move upward is perilous.
At the end of 2020, we saw markets recover strongly from the pandemic downdraft but since the beginning of 2021, our investment teams have been planning for any sudden movements in inflation with some disposing of their bond holdings already and using alternatives instead to manage the risk downwards. The April Inflation figure doubled to 1.4% but the market has not overly reacted, remember where the market was 12 months ago! Some of the investment managers have been buying commodities and I am certain more will be used if the spectre of inflation becomes a reality. Our clients’ portfolios are professionally managed so these risks are dealt with effectively, this is what the managers do every day!
If you require anything further, please speak to your Prosperis adviser on 01423 223640 or email us below.
