Will inflation finally re-emerge in a post-pandemic recovery, and how can a balanced portfolio prepare for it?
- Dominant structural deflationary forces are at play, and in spite of the extraordinary monetary and fiscal stimulus deployed in response to the pandemic investors appear complacent as inflation failed to take hold following the 2007-8 global financial crisis.
- Credit is expanding as central banks encourage lenders to stimulate the economy, but other conditions will need to be met before inflation follows, such as more pressure on wages and a rise in capacity utilisation.
- With government bonds providing low returns and limited risk reduction, we believe there is a case for increasing exposure to inflation-hedged assets.
There is no question that the disinflationary effects of the pandemic are likely to continue to dominate the backdrop over the short term. Moreover, there are dominant structural deflationary forces at play that are unlikely to change: excessive debt levels, an ageing population and technological disruption, to name but a few. These will continue to weigh on inflation measures for the foreseeable future. With inflation currently remaining very muted, the question is therefore whether the extraordinary fiscal and monetary stimulus deployed in response to the pandemic will provide an inflationary boost.
Cause for complacency?
Investors appear currently complacent as quantitative easing did not lead to inflation following the 2007-8 global financial crisis. There is a consensus view that this will remain the case for the foreseeable future. But is this correct, and, if not, how can we explain what happened over the last decade?
Monetary base, money supply and inflation are closely correlated. This means that, if central banks print money through quantitative easing, money supply and inflation go up, providing the velocity of money stays the same. However, following the global financial crisis, the monetary base grew but the money supply did not follow, as the money multiplier and the velocity of money fell. The money that was ‘printed’ did not translate into increased money supply as credit growth was anaemic. Indeed, almost all the money printed ended up at the US Federal Reserve and other central banks as excess reserves.
A boost for bank lending
Is the current cycle going to be different? Potentially. There are some signs that inflation could emerge in the future. Real yields will remain ultra-low and deficit spending is likely to continue to help the economic recovery. The Federal Reserve is now easing regulations and encouraging banks to lend to stimulate the economy. It is moving from punishing the financial sector, seen to be at the epicentre of the global financial crisis, to thinking about how to get banks to lend more and encouraging them to use their capital and liquidity buffers to that effect. This is a new development and there are some signs that such policies are starting to bear fruit. In addition to the significant increase in Federal Reserve assets and the substantial rise in the monetary base, for the first time credit is expanding at a double-digit rate, both in the public and private sectors.
However, there are other conditions that need to be met before inflation follows. We need to get beyond Covid-19 and economic activity needs to recover. Unemployment has to fall in order to put pressure on wages, and capacity utilisation needs to rise across industries to affect price levels. It is hard to gauge how quickly these conditions will materialise, but the risk of higher inflation in economies is an obvious consideration.
A capital allocator’s dilemma in a zero-yield world with higher inflation is centred on the question of how to construct a robust, balanced portfolio that can also withstand equity-market sell-offs.
It is pretty clear that, with interest rates near zero and being held stable by central banks, government bonds will provide low returns and, at best, moderate risk reduction. This argues for more exposure to inflation-hedged assets such as inflation-linked bonds, gold and real assets to achieve a balance, where investors would have previously relied on nominal bonds.
While replacing nominal assets that offer no yield with real assets that provide a yield could appear to be an obvious strategy in the scenario of a pickup in inflation, it is unlikely to solve the problem of capital preservation. Therefore what assets can serve as a tail hedge in an investment portfolio? Convex long option and volatility strategies, such as risk premia strategies with an asymmetric return profile, could help and, if structured effectively, the cost of hedging may not be prohibitive.
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