Investors need to decide whether the risk of inflation is real

Date: Tues, 18 July 2020

 Author(s): Michael Mackenzie

 Source: Financial Times


Is inflation finally making a comeback after a long absence – one of today’s markets most divisive questions.

Many investors seem to think so. In an attempt to protect their portfolios from the threat of of a run-up in consumer prices within the next 12 to 18 months, they have increased their exposure to inflation-linked bonds and gold.


This week, 30-year TIPS - Treasury inflation-protected securities with returns adjusted with moves in consumer prices – showed a demand so strong that the yield plumbed new depths, sinking close to minus 0.29 per cent, according to Bloomberg data. At the same time, there was a significant increase in funds investing in TIPS, contrary to the outflows seen in March and April this year. More than $5 billion rushed into these funds in the week ending July 8.


That came despite a recent stumble in core PCE, the US Federal Reserve’s favoured inflation measure, to 1.7 per cent, well below the central bank’s 2 per cent target.


With investors counting on a pick-up in inflation, it signifies the determination of central banks and governments working in unison to minimise financial markets turmoil from Covid-19 and to sustain an economic rebound.


As it is, the recovery in global trade has already lifted the price of industrial metals and oils. Iron ore has recently overtake gold for this year’s performance. Much of this reflects a credit upswing in China that should in theory bolster the global economy and corporate profits outside of the US, particularly in Europe and emerging markets.


Another potential source of inflation would be a sustained decline in the US dollar. The greenback’s slide from its March highs has boosted commodities and emerging-market asset valuations through a reduction in global funding costs.


It is not hard to imagine these trends gathering momentum. Governments around the world have turned on the spending taps and the willingness of central banks to step in and tighten policy is low. In addition, a rapid economic recovery still cannot be ruled out. Viewed in this light, one can understand why some investors think the risk of runaway inflation has risen.


Meantime, another possible scenario is that inflation could kick higher without the economic growth to go with it. Instead, the legacy of Covid-19, in terms of high structural unemployment and hefty debt loads — as well as higher taxes and a rising regulatory burden for companies — will suppress economies’ ability to grow.


Analysts at Bank of America have flagged that risk of so-called stagflation, which could entail a tougher time for fixed income and equities. Low fixed rates of interest provide scant protection against higher inflation, while debt laden companies would be challenged by a combination of rising interest rates and lacklustre growth. That would provide another reason for the current push for inflation-protected bonds and gold.


Beyond the competing scenarios of reflation and stagflation remains another outcome: more of the same, or an extended period of modest growth and inflation, accompanied by low bond yields and meagre rises in wages.


Sovereign bond yields sitting near their all time lows are a sign that economic stagnation remains uppermost in the minds of many investors. Bond fund managers are still awaiting evidence that the historic expansion of money supply in recent months will at some point push up prices in the broader economy. Only then will they shift from the disinflationary stance that has held since the last financial crisis.


Keyword :, Sterling House Trust, SHT