- Bond market yields imply rising inflation expectations
- Wealth managers don't expect that inflation will trigger a policy response this year
Over the past year, enormous stimulus packages have been launched to prop up economies and interest rates have been cut to record lows – in some cases negative levels. The US stimulus has been the most dramatic, with the broad money supply annual increase last year going from roughly 5 per cent to 25 per cent. This could lead to a rise in inflation as activity picks up.
Bond investors appear to be starting to anticipate inflation, with a sell off in global bond markets in recent weeks. Inflation is bad news for bonds, because it erodes the real value of the interest they pay, and it makes a rise in central bank rates more likely. The bond sell off has been, again, most pronounced in the US, with the election of Joe Biden and increasing likelihood of his $1.9 trillion (£1.36 trillion) pandemic aid package being passed.
Beyond market inflation expectations, it is important to look at what US central bank, the Federal Reserve, and the Bank of England think and do. Last week Federal Reserve chair Jerome Powell said that it could take three years to they reach their 2 per cent inflation goal, suggesting the bank is in no rush to cut back on stimulus. Powell also reiterated his view that there was a large amount of slack in the labour market, and said the true unemployment rate is significantly larger than the official rate which should have a dampening effect on inflation. The Federal Reserve indicated last year that it would not raise interest rates until the end of 2023.
David Miller, executive director at wealth manager Quilter Cheviot, says that there is a bit of inflation, but the things that are pushing it higher are food, fuel and other raw materials, which have suffered from supply chain interruptions and underproduction during lock downs. He says that this has caused demand led inflation rather than a problem with excess supply in the system. This makes it less likely that the Federal Reserve will respond with a rate rise as it should level out.
“What we are not seeing is inflation creeping into consumer goods or wages,” says Miller. He thinks that inflation should stay moderate and won't be high like in the 1970s.
Some people believe that there has been disinflation in the system for decades, and throughout financial crises, booms and busts inflation has stayed low for a long period of time. The disinflationary forces of technology, globalisation, and the impact of China and other parts of Asia on the cost of production, are unlikely to significantly change after the pandemic. Miller’s view is that “we will have slightly higher inflation, and it won’t change central bank or government policy.”
Others think that the unprecedented stimulus packages worldwide could prove significantly inflationary. There has been a spike in excess savings across the developed world as people have been less able and willing to spend, but there could be pent up demand for spending as restrictions are removed. Jason Hollands, managing director at Tilney, says that there could be about £200bn of excess savings in the UK as a result of lockdowns so when restrictions ease at least some of this will come back into the economy. “It is not unreasonable to expect that maybe a quarter will,” he says.
When upcoming inflation figures are published, particularly the April figures which in the UK will be published in May, they are going to look high because they are measured from the same point a year earlier when there was a significant fall.
Expectations of the economy picking up increases the likelihood of inflation and a rate rise. This has a negative effect on the price of growth equities because in such conditions the risk premiums people are willing to pay for these companies is not as high. These performed particularly well last year, but cyclical companies such as restaurants, hotels and airlines should do well if the economy picks up. This is why their share prices have jumped whenever positive vaccine news is announced.
Portfolio positioning
There is no clear outlook on inflation and interest rates so it is sensible to keep your portfolio diversified. In terms of equity exposure, if the opening of the economy goes to plan cyclical sectors should prosper. We have already seen cyclical companies in vogue, out of fashion and then back in vogue again this year. But many companies may not survive once furlough ends so you need to be careful with so-called value stocks.
While many growth companies are on very high ratings, these may be justified and these types of companies remain the firms likely to shape the future. (Read more on this in Style wars IC, 08/01/21.) Generally, most UK stocks provide cyclical exposure, while US technology, healthcare and sustainability stocks tick the growth box.
In terms of geographic allocation, Edward Park, chief investment officer at wealth manager Brooks Macdonald, says that they have increased the Asia ex Japan weighting in clients' portfolios to enhance the ‘balance.’
“We view this balance between growth and cyclical sectors as essential in 2021," he explains. "So far this year, we have witnessed a tug of war in market leadership between growth and cyclical exposures. Asia ex Japan equities have been one of the greatest beneficiaries of this cyclical swing and remain our preferred area for such exposure."
While bonds have sold off a bit recently, they still look expensive as the prospect of inflation looms. Miller says he has been reducing his bond exposure and moving into shorter dated bonds. Longer dated bonds have more price risk if interest rates or inflation expectations increase. While index-linked bonds are traditionally seen as products to provide an inflation hedge, these are not something Park invests in as he sees “little value in gilts, conventional or index-linked, at the moment.”
Gold is also held as an inflation hedge but has experienced significant price falls over the past couple of months following a sharp rally last year. Miller says he has been reducing gold because while it proved to be a nice insurance policy last year, as bond yields rise and the economic outlook improves this asset is less compelling.
Property and infrastructure are other assets that could provide an inflation hedge. Infrastructure funds have been particularly popular in recent months as they often hold assets with 20 year-plus contracts that have inflation proofing built in. However, if corporation tax rises these funds look vulnerable. As we discussed in the issue of 19 February, wealth preservation trusts can also provide inflation protection.
If inflation picks up, cash could lose its real value quite quickly. Ryan Hughes, head of active portfolios at broker AJ Bell, suggests Fidelity Short Dated Corporate Bond Fund (GB00BDCG0F15) as one option for trying to get a better return than you get from cash right now. The fund has an effective distribution yield of around 4 per cent and invests in a portfolio of short dated investment grade bonds with an effective duration of around 2.5 years. It doesn’t guarantee inflation proofing, but it has the potential to eek out a little extra return over the next 12 to 18 months.
