Should investors worry about inflation?
Many investors are concerned that inflation is a threat that could upset the upbeat outlook for equities and corporate credits in 2021. Some are worried that we could get a “Taper Tantrum 2.0” if central banks were forced to unwind accommodative policies early because of inflation concerns. In short, headline inflation may pick up modestly next year, but we believe central banks will take a patient approach when planning for policy normalization.
Headline inflation has room to rise modestly. First, the COVID-19 pandemic and subsequent recession has suppressed consumer prices. Commodity prices collapsed in the first half of 2020. For example, crude oil (WTI Cushing) price averaged USD 28 per barrel in the second quarter of 2020. If this stays at the current price of USD 45 per barrel, this would represent a 61% year-on-year rise in 2Q 2021. The same applies to many consumer services that was discounted to attract customers. This low base of 2020 could push headline inflation in the U.S. higher, and potentially above the Fed’s target of 2%. As the U.S. and global economies gradually recover from COVID-19’s impact, some bottlenecks could also emerge and lead to temporary rise in prices.
However, given the sharp drop in output over the past nine months, developed economies have room to expand before reaching capacity constraints. For example, the U.S. is expected to return to its pre-pandemic level in real gross domestic product only by the end of 2021. Eurozone, Japan and the UK could take even longer. This shortfall in economic activity, relative to potential, indicates that demand-led inflation is still some time away.
We also expect central banks to interpret the rise in inflation as transitory and be patient with normalizing policies. While investors are excited to see breakthroughs in vaccine development to bring economies and corporate earnings back on track in the long term, many sectors could still take months to begin recovery (think airlines and tourism). This implies the liquidity support from central banks is still much needed to facilitate this recovery. Governments are still expected to maintain sizeable fiscal deficits in 2021, which would need financing from central banks. Even if we see government bond yields rise modestly in 2021 and reflecting a brighter economic outlook, the magnitude of this rise would be capped to avoid governments’ interest payment costs from rising too much and further undermining their fiscal position.
Central banks have gone through a subtle shift in their role on ensuring price stability. In the past, their objective has been to prevent inflation from rising too much. Now, they need to ensure there is some healthy inflation in the economy and avoid deflation. This is reflected by the Federal Reserve’s revised monetary policy framework to target average inflation over a period. It is also worth recalling the sequencing of policy normalization after the global financial crisis. The Federal Reserve began with tapering asset purchases in 2013 and began raising policy rates in late 2015. The same sequence could apply in this recovery, exiting its quantitative easing program first before adjusting policy rates, ensuring a positively sloped yield curve.
EXHIBIT 1: UNITED STAES: INFLATION
Central banks taking a more patient approach means room for risk-free rates to rise is limited. This would encourage capital flow into corporate credits, emerging market fixed income and alternative assets that have attractive income-generating characteristics. We are aware that the corporate credit spread for U.S. high yield debt is approach the pre-pandemic low. This implies the source of returns is likely to come primarily from coupons, instead of credit spread compression.
Meanwhile, the ongoing economic recovery and modest pick-up in inflation should be good news for cyclical sectors in the equity market. As we highlighted in our 2021 Year Ahead, sectors that were the worst hit by the pandemic, such as materials and energy, consumer discretionary (travel, food and beverage), financials and industrials, should benefit. A pick-up in headline inflation would also indicate some of their pricing power is returning.