Crystal Wealth Newsroom

Will inflation return?


When it comes to inflation, it has been rather subdued for a long time and if anything the concern has been more about disinflationary effects taking hold (e.g. the Japan experience). But as the economy emerges from the COVID recession, we expect to see higher inflation emerge as a result – partly due to the government stimulus packages and fiscal support, both here and in the US.

It’s important to note that seeing higher inflation readings in this situation isn’t unusual, and in fact, it’s generally a good thing in terms of mapping the pathway of economic recovery. In reality, at this point, the market focus has been on ‘reflation’ from a lockdown rather than structurally higher inflation.

The recent jump in core inflation readings is certainly one to keep an eye on, and there are two issues the markets will be carefully watching moving forward.

The first is the expectations of inflation because a change in inflation expectations is an important driver of future asset returns, and there have been false starts with past inflationary alarms. If people start factoring in higher inflation to their pricing and savings decisions – both in terms of consumption and wages – then this feeds into what they’re asking for in return. Then it risks becoming something of a self-fulfilling prophecy, and we see inflation escalating. Within this context, inflation-linked bonds, commodities and real assets generally do well.

The second is the current data points, which are moving around significantly. Last week, for example, in the US, headline inflation jumped 4.2% (or 3% for core) – the fastest increase since 2008 and significantly ahead of predictions – while the job creation numbers for April in the US were way behind what was envisaged. This is the type of conflicting signal that is making it difficult to get a clear read on the current outlook.

We expect this trend to continue for now – we are going to see more ‘misses’ and ‘surprises’ compared to expectations or what forecasters are estimating, and that’s just the general market dynamic we’re in at present.

But all forces are not inflationary. We still have an ageing population and the effects of technological innovation to contend with, for starters. Yes, the increase in commodity prices is inflationary and there are supply chain blockages that are inflationary currently – particularly in critical components such as computer chips – however, the consensus is these effects are largely transitory rather than a permanent structural change to runaway inflation.

Of course, one of the most significant factors in the equation is the on-again/off-again COVID recovery around the globe. We’re clearly not firing on all cylinders, and it’s a multistage recovery as not everyone is progressing at the same rate or reopening at the same rates (both here and abroad). For example, there is still significant slack in the economy to resolve (e.g. USA), particularly with work participation rates.

Looking forward, we should see a reasonably strong rebound in the economic data print, and there’ll be some high year-on-year trends, primarily because we’re coming off a low base, and that’s why GDP and inflation changes are going to look large for now. Note that globally central banks haven’t moved cash rates at this point in the cycle, as they are looking for more wage-based inflation to move the dial first.

This means we should see higher inflation readings before rates move. The effects of current monetary and fiscal stimulus should lead to a higher level of inflation than what existed pre-pandemic and this could also lead to higher bond rates in the near term, as the bond market will look forward and some of these adjustments have already been made.

Over the next three months, it’s going to be interesting to watch as we’ll see more data points pointing at higher inflation, but we’re all trying to look through this to see if it really has moved or it’s just temporary. The rebound is from a low level and expected inflation will be higher in this environment of better growth prospects.

Over the next quarter or two, we expect some of the temporary supply effects to have been resolved, and those bottlenecks freed up, which means some of those market factors contributing to inflation will ease. In reality, too much inflation is a problem but then so too is too little inflation and this is a risk still out there.

When it comes to investment strategies, we think it’s wise to have some protection for inflation, including commodities, variable rate loans, real assets and companies that have the ability to pass on higher prices to customers, but we certainly don’t think this is a ‘genie out of the bottle’ moment that means we should look to rotate substantial parts of the portfolio. Overall portfolio structure and balance remains important here as market timing is notoriously difficult in such times.

So, in answer to the question, will inflation return? The answer is yes – it has already. However, significant inflation will require more structural shifts, not temporary price moves, to generate permanent regime change in the inflation outlook.

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