Inflation: Transitory for longer
Increasing consumer demand, raw material shortages and prolonged supply chain disruptions have conspired to ensure inflation remains abnormally elevated, but we still believe this backdrop will ultimately be short-lived.
There are even now signs that US inflation may already have peaked. The US consumer price index (CPI) rose 0.3% in August, the smallest increase since January, after gaining 0.5% in July. On an annual basis, CPI increased 5.3% after jumping 5.4% year-on-year in July1 .
In the Eurozone, annual inflation was 3.4% in September - a 13-year high. The European Central Bank has argued that one-off factors - such as supply bottlenecks - account for much of this surge, and that price growth is expected to moderate in early 20222 .
We anticipate that US inflation will persist above the 4% mark before falling back sometime at the end of the first quarter (Q1) of 2022. We also expect Euro area inflation to remain close to 2.5% until the end of Q2 2022, and to start to ease thereafter, as supply chain problems recede, and demand normalises.
However, when price increases start moderating, we believe they will remain relatively high by historical standards. As such, by this time next year, we expect US and Eurozone inflation respectively to be around 2.5% and 1.5%.
And we are not alone in believing that inflation will not return to zero; the Organisation for Economic Co-operation and Development has warned that it expects prices across the G20 to grow faster than they did prior to the pandemic for at least the next two years.3
Risks to the inflation outlook
While we do believe that higher inflation will ultimately be transitory, it is important to monitor the risks. Forecasting inflation is inherently difficult even for the experts. Prices can be skewed by unexpected or one-off factors such as extreme weather events or sudden shortages - and there are other high-level risks to consider.
For some time before the coronavirus pandemic began, many economies had been experiencing a period of moderate growth and moderate inflation. Companies had longer visibility on likely business conditions and as a result, economic cycles have been longer. However, the pandemic changed all that – and as economies have emerged out of lockdowns, there have been periods of ‘stop and go’, which has made many companies reluctant to expand production capabilities – leading to a more volatile economic and inflation outlook.
At the same time, the drive to ‘build back better’ and to focus on a green transition towards a lower carbon world could push prices of some raw materials higher. However, inflation measures are adjusted to account for the fact that more expensive products can sometimes be of higher quality – a process known as hedonics. If electric vehicles for example become more advanced while their cost remains the same, this could actually push inflation lower.
Another risk to global inflation is policy changes in China, the world’s second-largest economy. As China starts to rotate its growth model from exporting to consuming, its role as the world’s factory, could diminish – and this could have a significant impact on prices. Meanwhile, the current energy shortage in China is forcing some factories to limit production, which also has an inflationary impact.
The biggest short-term inflation risk that I see right now is the wage-price loop, due to a labour shortage, as economies exit from lockdowns. Wages in many areas are increasing to entice the workforce back – and higher disposable income tends to increase demand for goods and services, making prices rise. Rising prices then increase demand for higher wages, which can create a pricing loop that potentially only ends when interest rates rise.
Monetary policy and investment strategy
While we continue to expect the current inflation shock to prove transitory, we have to admit that “transitory” has become harder to define as inflation has continued to surprise to the upside.
This is setting the scene for central banks to normalise monetary policies – in fact inflation is currently higher than it was during previous periods of monetary policy tightening. The Federal Reserve is expected to make an announcement on slowing its asset purchases at its November policy meeting, with the tapering process to start shortly after and finish by the middle of next year.
There was also a shift forward in interest rate expectations from the Fed’s interest rate-setting committee, with the first hike potentially as early as 2022. In addition, at its September policy meeting, the Bank of England signalled that it may be the first of the major central banks to raise interest rates, possibly before year-end, although we expect it will more likely occur in 2022.
Given this backdrop, my preference is to hold inflation-linked bonds at the front end of the yield curve – those with shorter maturities - which are potentially better shielded against higher interest rates.
I also favour short-duration inflation-linked bonds because they have historically had a greater sensitivity to commodity prices. In addition, their total return is more closely correlated to inflation indexation, which we expect to remain supportive in the coming month as inflation continues to be a hot topic.
In the Eurozone, it looks as if quantitative easing has been a permanent feature of monetary policy while inflation is remaining relatively low. This is another risk however, as at some point, policy will change. Holding short-dated French and German government bonds can be a proxy for higher inflation breakevens – the difference between the nominal yield on a fixed-rate investment and the real yield on an inflation-linked bond - while potentially protecting against a policy shift.
In the US, I prefer hold one to two-year Treasury Inflation-Protected Securities (TIPS) for the positive carry from the bonds’ inflation indexation, but I would rather remain underweight in five-year and longer TIPS that I believe are exposed to the tapering of asset purchases.
Looking back at 2021 so far, the inflation shock has been massive. Earlier this year, economists were expecting Euro area inflation to peak around 1.5% while it is now likely to peak well above 4%. While we believe that inflation will ultimately prove to be transitory, this year proves that it can surprise to the upside without warning. For now, maintaining a level of inflation protection in investment portfolios looks to be one of the most potentially appropriate strategies even in the face of the expected upcoming monetary policy normalisation.