Inflation fears driving market sentiment

Key points:

• High hopes of a vaccine-fuelled economic recovery
• The expected recovery and large fiscal programmes add to price pressures and inflation forecasts
• Some factors suggest such pressures are transitory and central banks seem to concur, with US interest rates likely to be on hold this year and next
• That said, even moderate price rises can start to hit wealth preservation assumptions
• Portfolio diversification is key to weathering inflation.

Rising inflation expectations has sent a tremor through financial markets since February, fuelled, in part, by a vaccine-driven economic recovery, overwhelming fiscal support and stronger commodity prices. Similarly, government bond yields have climbed as investors questioned the commitment of central banks to keeping interest rates at historically low levels.

It may be prudent for investors to consider prospects for inflation, and the subsequent risk of rate hikes, along with whether to adjust portfolios to mitigate such risk.

Recovery hopes

The rollout of vaccines in much of the world is accelerating the timeframe for activity to return towards pre-pandemic levels. The rollout promises fewer fresh infections and improves prospects for a services revival and ultimately employment prospects.

We now project that the global economy will grow at 6.4% this year, up from a 5.6% forecast in January.

Fiscal commitments adding to inflationary pressures

Government spending, in response to the pandemic, is adding to inflationary pressures. The International Monetary Fund estimated in January that governments have committed $14tn to pandemic-related measures.

President Biden’s $1.9tn recent relief bill, the second largest US stimulus package, includes direct cheques to consumers, extension of unemployment benefits and funds for vaccination distribution programmes. The aid should temporarily supplement income and government spending during the coronavirus outbreak.

And a supercycle in commodities is a risk

Commodity prices form a high weighting in consumer price indexes and can quickly influence inflation forecasts. The anticipated robust recovery (particularly in commodity-intensive economies such as China), aggressive infrastructure investment and climate change initiatives have conspired to push energy, metal and agricultural prices higher.

The total return on the Bloomberg Commodity Index is 34% over the past year. Some believe that a commodities supercycle is on the cards. If the upward momentum in commodity prices persists they would push prices higher, particularly in regions that import substantial quantities of raw materials.

Are pricing pressures transitory?

It’s perhaps no surprise that year-on-year inflation may rise this year in the UK, Europe and US by one percentage point, given the broad range of inflationary pressures being faced by economies.

Despite the upward pressure on inflation, some factors suggest they may be transitory. Unemployment rates are above pre-pandemic levels, yet the wage growth typically associated with core inflationary pressures has not being seen. The rapid digitisation and investment in technology being experienced may limit wage growth for some time.

The arresting of the coronavirus outbreak is far from assured and may take a considerable time yet. The road to freedom could be infringed upon by different vaccination rates in regions. Unknown vaccine efficacy levels against new variants could also affect the recovery and, in turn, inflationary pressures.

Short-term inflation outlook

Barclays forecasts that the US Federal Reserve’s (Fed) preferred domestic inflation level, the core personal consumption expenditures (PCE) index, will hit 2.2% in the second quarter, easing to 1.8% in the third quarter and 1.9% in the fourth, then averaging 1.8% in 2022. While the forecasts suggest that euro area CPI will average 1.5% this year and drop to 1.1% in 2022, UK CPI looks set to average 1.9% this year and 1.8% next.

Is tighter monetary policy on the cards?

The impact of stronger inflationary pressures on monetary policy is likely to be more muted than this year’s increase in bond yields hints. Inflation forecasts remaining below central banks’ target levels. As such, the Fed, European Central Bank and Bank of England seem likely to keep rates on hold this year and next.

Investors beware

Investors need to generate a return equal to, or preferably higher than, inflation to preserve the long-term purchasing power of their wealth. That said, even moderate price rises can start to impact wealth preservation assumptions. For those focused on protecting their wealth, a range of options are available to manage inflation risk by using equities, fixed income and precious metals.

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