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Pound coins

Why inflation could be a surprise

Major central banks have recently signalled a slower pace of rate rises than had been expected. While our economists do not expect a large increase in inflation this year, there is a risk that higher inflation takes markets off guard.

Economic growth and inflation are likely to be around long-term averages in the short term. In response to a growth scare in the fourth quarter (Q4) of last year, and resulting fall in commodity prices, most central banks shifted their focus to growth risks as inflation pressure subsided.

That said, after a long period of relatively subdued inflation and with little sign of a sharp pick-up recently (see chart below), there are many factors that could push inflation higher.

Citi global inflation index

Factors that could drive inflation higher

There are several risks that could trigger higher inflation in the second half of 2019:

  • Unemployment rates are low across most developed markets and companies are expressing difficulty finding the right candidate to fill vacancies. This ratio is close to an all-time high in the US small business survey for example. Although the level of wage inflation remains subdued, the acceleration seen in recent months could persist.
  • Most countries in the developed world will increase fiscal spending in the next couple of years, according to the Organisation for Co-operation and Development. Barclays’ economists also expect a fiscal stimulus later this year in China, Germany and Japan.
  • While we expect trade tensions to ease in the short term, a failure to find an agreement between the US and China would likely trigger a significant increase in the price of goods.
  • Commodity prices have rebounded from their lows of late. While still likely to temper year-on-year inflation in the second half of the year at current levels, there is a risk that prices continue to rise.

In the longer term, the increasing emerging market (EM) middle class and its expanding purchasing power will lead EMs to no longer export lower inflation but rather higher inflation to the rest of the world. In the developed world, the debate around the use of quantitative easing to finance government deficits is likely to also generate discussions around inflation risks.

Percentage balance of replies

Inflation and financial assets

From a financial markets point of view, we look at how portfolios can be positioned to minimise the risk in case of renewed inflation pressures. The main takeaway is that cash holdings should be reduced to the bare minimum to meet liquidity needs.

With cash on deposit returning very little at the moment, inflation is the most significant risk for cash holdings. For investors holding cash in the belief of an imminent recession or market downturn, we believe that gold is a more attractive proposition.

With the Fed signalling that US rates are firmly on hold, higher inflation would translate into lower real yields. Gold tends to benefit from a fall in real yields as its drawback of not paying income becomes less relevant.

Another hedge against inflation is to invest in physical assets such as property. Compared to financial assets, physical assets have not benefited as much from the flood in liquidity seen since quantitative easing started. However, the increased focus towards infrastructure, fiscal spending and a more even distribution of revenues between capital and labour would make the asset class more appealing.

Focus on companies with pricing power and low price sensitivity

As a whole, moderate inflation tends to be positive for equities as it supports revenue growth. That said, the main cause for inflation should be analysed before making investment decisions.

If inflation fears are driven by faster-than-expected wage growth, while companies exposed to consumer spending may benefit, this may be more than offset by higher labour costs. On the other hand, should inflation rise due to higher energy prices, then producers will benefit but many purchasers of energy may suffer.

Some companies may withstand the effects of inflation better than others. We believe companies with strong pricing power (eg luxury brands), low price elasticity (staples) or inflation-indexed revenues (concessions) look better positioned to do so than many others.

Whatever causes inflation, the sequences of events will be crucial. Indeed, if markets start believing inflation is rising without the support of strong economic growth, investors may question the sustainability of the economic cycle. 

This could hurt equity markets, as happened in 2018 when yields moved higher as growth started to fade. As we would not expect this to happen this time, instead we would focus on companies with pricing power, product demand that is little affected by price changes or with inflation-indexed revenues in times of rising inflation.

Focus on US dollar inflation-linked bonds

Fixed income investments and inflation do not usually go hand in hand given that any unexpected inflation will eat into the nominal coupon and repayment of debt instruments.

Institutional investors, with pension funds primarily use inflation-linked bonds in order to manage inflation risk. But like anything in financial markets the hedge comes with a price tag. In this case it comes in the form of the real yield (nominal yield adjusted for inflation) rather than the higher yield nominal bonds offer.

Breakeven rates are used to assess the relative attractiveness of inflation-adjusted yields compared to the yield of nominal bonds. In the US, 10-year breakevens are just short of 2%: the implied average yearly consumer price index over the next 10 years.

This is similar to the average of the past 20 years but well below of the average in the last 40 years, for example. In the UK, breakevens have been highly distorted by FX volatility and concerns around Brexit-related inflationary shocks. At 3.2% the 10-year breakeven does not appear cheap. The UK retail price index (RPI) and consumer price index will likely fall further from their 2017 peak, according to the latest BOE forecast update.

With the recent strength in sterling against the US dollar and the diminishing risk of a hard Brexit, it is hard to imagine the RPI shooting up significantly above current breakeven levels (see chart). For sterling investors, better opportunities in physical assets, such as real estate or infrastructure, are likely to exist.

Inflation linked bonds
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Market Perspectives April 2019

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