The uncertainty surrounding the path for inflation comes from the pace at which economies are absorbing economic slack.
Global Market Strategist
The market is grappling with just how strong inflation pressure in the U.S. and around the world will be in the coming months and years. Central banks are prepared to look past any short-term spike in inflation as they wait for signs of more persistent price pressures that signal a more robust economic base. The risk is that inflationary pressures are more persistent than expected, leading to a disorderly rise in bond yields and potential selling in equities.
Inflation was slow to return after the global financial crisis despite the fears that the introduction of quantitative easing and surging liquidity would create runaway price rises. Similar fears are present in today’s market as economies, such as the U.S., are at the intersection of fiscal stimulus and herd immunity and there is the potential for much stronger-than-assumed rates of inflation. However, history is not always a good guide and there is greater uncertainty around the inflation outlook today.
In the near term, the base effects of comparing prices from their lows a year ago to today means that inflation will be higher. Additionally, the release of pent-up demand and “revenge spending” by reinvigorated consumers, the large swing in commodity prices, as well as the temporary supply constraints and shipping cost increases, all mean that inflation rates will be well above central bank targets in the coming months.
Beyond the near term, inflation pressures should recede. The mismatch between supply and demand will fade as supply constraints are remedied and inventories are rebuilt. Moreover, the areas in which spending occurs will likely change. When overall inflation was slowing, goods price inflation were still rising as mobility restrictions meant consumers spent more on things for their homes. With those restrictions now being lifted in many countries, spending habits will reorient away from goods and towards services and spending outside of the home. The net effect of this shift in spending may result in less of a boost to overall rates of inflation from consumption than assumed.
The uncertainty surrounding the path for inflation comes from the pace at which economies are absorbing economic slack. The aggressive use of fiscal stimulus to bridge the economic divide created by the pandemic means that the early stage of this economic cycle could be short-lived compared to history and bring inflationary pressures back sooner. This is especially the case for the U.S. where stimulus measures are still being utilized. USD 1.2trillion of the USD 1.9trillion March stimulus package, 5% of U.S. GDP, will hit the economy by September this year.
One way to measure the slack in the economy is to look at the labor market. After the global financial crisis, it took more than seven years for the U.S. unemployment rate to return to pre-crisis levels. This time around things are improving much faster. The U.S. labor market has already reversed 75% of jobs lost during the pandemic and the U.S. Federal Reserve is forecasting a return to a pre-pandemic rate of unemployment of 3.5% by the end of 2023. A labor market recovery in less than four years is already fast, but has the potential to be faster still, creating more sustainable inflation pressures as wages rise.
Exhibit 1: Inflation expectations remain well-anchored
Market-based inflation expectations
To date, inflation expectations remain relatively well-anchored, which suggests a more orderly rise in bond yields linked to improving growth outlook, and steadily-building inflation rather than a sharp move higher. However, the risks around the inflation outlook should not be dismissed given the uncertainty surrounding the multitude of factors that may influence price movements.
The inflation outlook varies by country given the degree of slack which remains and the pace of improvement. But broadly, the accelerated pace of vaccine distribution across the developed world will facilitate an economic re-opening, leading to improving rates of economic growth, rising rates of inflation and higher government bond yields. The expectation for a relatively orderly rise in yields means that equity markets should continue to perform well as earnings rise and alleviate some of the valuation pressures. Steeper yield curves as long-dated bonds rise and central banks continue to anchor the short-end of the curve adds fuel to the rotation to value-oriented stocks and cyclical sectors. However, investors may wish to focus on companies that can maintain pricing power as input costs rise to protect margins.
In fixed income markets, investors should focus on short duration or areas where the yield can offset the expected capital loss. This includes short duration positions in credit or higher income segments of the bond market, such as high yield bonds and emerging market debt. For investors worried about inflation overshooting, commodities and real assets that have inbuilt inflation protection have historically generated positive returns in periods of low and rising inflation.