Investors spent 2020 worrying about Covid-19 but now there’s a new enemy making stock and bond markets nervous: inflation.
While the world hasn’t “beaten” coronavirus yet, the vaccine combined with trillions of dollars of government stimulus is expected to jumpstart the global economy this year. But will this spark inflation and a rise in interest rates, bringing the “lower for longer” era to a swift end? We look at the inflationary worries that keep fund managers awake at night – and what you can do to protect yourself.
Reasons to Fear Inflation
Some economists expect the vast amounts of government spending worldwide to trigger inflation (as has happened in the past). Larry Summers, who worked for both Clinton and Obama administrations, says the recently approved $2 trillion stimulus package signed by the new US President could spark inflationary pressures we haven’t seen for decades.
Investors should not treat these warnings lightly. Inflation has caused economic havoc in earlier decades, especially in the 1970s and in the early 1990s in the UK – and stock markets have generally suffered during inflationary periods. A sharp rise in the cost of living usually triggers a rise in interest rates – the Bank of England rate was around 14% in 1990 – and that makes life more expensive for consumers and businesses.
In simple terms, a rise in mortgage payments and loan costs means people have less to spend, save and invest. For companies, higher interest rates mean they spend more servicing debts and paying higher wages to workers whose costs have suddenly risen, which eats into profits.
Lower profits keep share prices subdued, which affects investors in shares and funds, and reduce the levels of dividends companies can pay out. In recent years though, cheap money has pushed many world stock markets to record highs, as low interest rates on cash and bonds drive investors to take more risk to get better returns and some sort of income.
Lockdown has caused widespread economic hardship but some people are not sure what to do with their spare money (particularly in the US where governments have been handing citizens cash): we’ve seen the possible effects of this in 2021 already with GameStop phenomenon and the spike in Bitcoin prices.
Reasons Not to Worry
While inflation concerns have picked up recently, the likes of the Federal Reserve, Bank of England and European Central Bank are not too concerned yet. Bond yields may have pushed up but they are still very low by historical standards. “Central bankers insist that they don’t fear inflation; it’s the devil they know. They’ve defeated it before and are confident that they can bring it under control,” says Sonal Desai, chief investment officer of fixed income at Franklin Templeton.
Investors get nervous when bond yields spike, as they did at the end of February, but this should be put into context, says Gareth Isaac, chief executive of fixed income at Invesco: “It’s a very positive sign that we’ve started to see an uptick in bond yields. Inflation expectations have picked up but that’s an entirely normal and heathy thing for the markets to do.”
Isaac adds that while the consensus is for a rise in short-term inflation as economies re-open, central banks are unlikely to raise interest rates unless they see higher prices becoming a long-term problem. The Federal Reserve has hinted that it’s prepared to let the economy "run hot" before acting for fear an interest rate hike will derail the recovery in the early stages. In its March 18 meeting, the US central bank said that interest rates are likely to remain on hold until 2024.
How to Invest for Higher Inflation
Some investment trust managers are nevertheless keeping a close eye on inflation and adjusting their portfolios accordingly. The managers of the Bronze-rated Ruffer Investment Company (RICA) are concerned about the inexorable rise in government debt during the crisis and have to added a small position in Bitcoin as protection against market volatility.
“Our conviction of an inflationary end to these events is unshaken, but at some point markets are going to test central bankers’ resolve to keep interest rates nailed to the floor once economies showed signs of recovery,” say managers Hamish Baillie and Duncan Macinnes. Index-linked bonds, whose payouts rise in line with inflation, make up nearly 30% of the portfolio, and the trust also owns some gold and gold equities. Morningstar rates a number of index-linked funds with an Analyst Rating of Bronze, including iShares Index Linked Gilt Index and Royal London Index Linked Fund.
Meanwhile, the manager of the JP Morgan Global Core Real Assets (JARA) investment trust, Philip Waller, has looked back at previous inflationary periods in the 1970s and 1980s as a guide. In these decades real estate and infrastructure assets outperformed the S&P 500. He says that both these assets can benefit from higher inflation because index-linked contracts are common. The trust has a 30-50% exposure to global real estate, which tends to perform well in times of high inflation – the price of commercial property, for example, tends to climb in these periods and rental yields increase to keep up with inflation.
Gold is traditionally used as an inflation hedge and the yellow metal surged in the crisis months of 2020 as investors sought out a traditional safe haven in the turmoil. But the price has been falling recently even as inflation fears have been rising, with gold losing around $200 an ounce to $1,700 since the start of the year. Whether Bitcoin is the new inflation hedge is hard to tell at this stage. "Gold is far from a perfect hedge against inflation and market tail risk. But then again, nothing is," says Morningstar's Alex Bryan.
