Should Investors be Worried About Inflation?

Our latest blog extracts a recent article by Michel Perera from Canaccord Genuity Wealth Management, a very popular asset manager among our clients. Here we can read Michel's insights into the prospect of global inflation and the implications this may have for your portfolio.
 
Markets have not been straightforward this year. On the surface, equity indices are positive; underneath, swan-like, there has been a lot of action with large differences in performance between growth sectors (healthcare, technology) and value sectors (energy, materials, financials). This has given the impression of massive drops in certain sectors and the word ‘tantrum’ has been revived from the 2013 ‘taper tantrum’ episode. In 2013, markets were concerned that the US Federal Reserve (Fed) would stop buying assets (mostly US Treasury bonds) from the market. As a result, the whole bond market repriced with a ricochet slump in equities. ‘Tantrum’ has therefore come to be associated with a market correction. 

Why are markets concerned about inflation? Current market worries come against the backdrop of fears of surging inflation. But are these worries overdone?

Last year, at this time, the pandemic caused inflation to collapse all over the world, setting a very low comparison threshold for this year’s prices. Inflation is generally measured as the rate at which the prices of goods and services bought by households rise or fall over 12 months, hence the starting point matters enormously. Plus, as a result of lockdowns, partial re-openings and supply chain issues, many bottlenecks have emerged which will inevitably cause certain prices to rise. It doesn’t take much more than that for the market to expect soaring inflation - and hence the prospect of the Fed stemming it by raising interest rates.

What is the Fed’s outlook for interest rates and inflation?

While the Fed has steadfastly confirmed that it will not raise interest rates for years (2023 at the earliest), it has not ruled out tapering its asset purchases (at this stage, they think there is enough liquidity in markets and don’t necessarily want to add more), which is why a tantrum is feared. Given that government bond yields have soared this year, from 0.9% to nearly 1.7% for the US 10-year bond (and from 0.19% to 0.82% for the UK 10-year gilt), markets are concerned that the Fed reducing its purchases will mean yields soaring further - and a bigger correction in equities.

Even last week, Fed Chair, Jay Powell, re-stated that interest rates will be on hold for at least two years and that short-term spikes in inflation will be tolerated, as the Fed doesn’t believe that higher prices will stick for long. His explanations have been very clear but nevertheless are not believed by markets who persist in believing that a string of high inflation numbers will trigger higher interest rates much sooner than the Fed indicates.

The Fed’s inflation gauge - the Core PCE (Personal Consumption Expenditures) Price Index - has been consistently below the Fed’s target of 2% during the whole of the last economic cycle, with a couple of brief exceptions. Chair Powell has announced that, from now on, the inflation target will not be an absolute number but an average number over a long period. Given that Core PCE has lagged its 2% target for 12 years, the Fed is saying it would be willing to wait for a few years with inflation above the 2% target before stepping on the brakes. Once again, markets are unconvinced and look for signs that a spike in prices will cause an interest rate hike soon.

Is the Fed’s interest rate policy likely to be reversed?

It is inevitable that we will see some nosebleed inflation readings in the next few months, but unless they are sustained for the whole year at least, it is unrealistic to expect that the Fed’s interest rate policy will be reversed so soon after announcing it (the last Fed policy lasted 40 years). Will markets pay attention to what the Fed says and does, or will they keep expecting the worst? Eventually, markets will get the message, but there could be some moments of extreme concern caused by inflation tantrums.

What can investors do if there is a market correction due to inflation concerns?

Anyone underinvested may want to consider purchases of risk assets like equities. Why? Simply because we have never seen the current favourable alignment of planets in the investment world:

• Loose monetary policy for years regardless of inflation levels
• The largest level of fiscal stimulus since WWII
• Individual investors sitting on the largest cash balances seen in decades
• Companies also enjoying the healthiest balance sheets in decades
• Vaccines now available to start taking us all out of lockdowns.

If the Fed is not going to raise interest rates, then the backdrop is the most conducive in many economic cycles.

What if inflation does indeed take off?

Of course, investing is not just about having a view, but also about preparing for alternative scenarios. There are several ways to help protect an investment portfolio from rising inflation:

1. Equities are generally the asset class of choice when inflation rises, as companies can generally pass on their costs more easily (with some value sectors likely to benefit most)
2. Inflation-linked bonds can offer better protection from increased inflation
3. Gold and certain commodities (industrial metals, energy) are also generally geared to higher prices. These investments can be woven into a balanced investment portfolio meaning an inflation spike need not be wealth-destroying for investors.

A bull market, where equities are rising and expected to continue rising, has often been said to ‘climb a wall of worry’, as many market participants fear something will go wrong. In this case, it seems that the market is already bent on anticipating tears at the end of a cycle which has only just begun. Markets don’t believe central banks when they say rates are not going to rise soon. Yet, historically, it has paid off to heed their words. ‘Don’t fight the Fed’ is the best-known Wall Street adage. Maybe we should listen more carefully.

By Michel Perera
Chief Investment Officer at Canaccord Genuity Wealth Management

Investment involves risk. The value of investments and the income from them can go down as well as up and you may not get back the amount originally invested. Past performance is not a reliable indicator of future performance.

The information provided is not to be treated as specific advice. It has no regard for the specific investment objectives, financial situation or needs of any specific person or entity.

This is not a recommendation to invest or disinvest in any of the companies, funds, themes or sectors mentioned. They are included for illustrative purposes only.

The information contained herein is based on materials and sources deemed to be reliable; however, Canaccord Genuity Wealth Management makes no representation or warranty, either express or implied, to the accuracy, completeness or reliability of this information. All stated opinions and estimates in this document are subject to change without notice and Canaccord Genuity Wealth Management is under no obligation to update the information.