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Inflation: The threat rises

15 Jul 2021

With fears that inflation is rising, Andrew Holt looks at the arguments and, if it happens, what it could mean for institutional investors.

No economic issue has been debated more often this year than inflation. Analysts, investors, asset mangers, politicians and central bankers have all given their views on what is happening to inflation, where it will lead and what it will mean.

The crux of the debate can be summed up by two simple positions: on one side is the view that we are approaching a situation where inflation is going to become a danger, with massive negative ramifications for the global economy; or we are seeing nothing more than a temporary blip and therefore there is nothing to see here.

So, how can investors navigate through the maze of conflicting opinion? The data is a good starting point.

According to official measurements, the rate of inflation is going up. Consumer price inflation in the US hit 5.4% – its biggest rise since the onset of the global financial crisis in September 2007. Meanwhile, in the UK, it climbed to 2.5%, exceeding the Bank of England’s 2% forecast.

Those concerned with rising inflation cite these figures as evidence of major problems to come. At the same time, the US Federal Reserve’s chair along with the governor of the Bank of England retort by quoting Taylor Swift: “You need to calm down.”

Learned economists and financial historians have compared the situation to the 1970s, when inflation was rampant, while the more dystopian are expecting to see a repeat of the dark days of the 1930s.

Nothing to see here

Taking the temperature of the market, nearly three-quarters of fund managers believe inflation will be short lived, according to one investor survey.

That survey found that 72% of investment professionals view the current state of rising inflation as ‘transitory’ – putting them in the territory of supporting the positions held by the Fed and the Bank of England.

Still, fund managers do not believe inflation has peaked, with 64% of the survey’s respondents predicting rises in the cost of goods and services during the next 12 months.

A big voice against the Bank of England’s position is one of its former chief economists, Andy Haldane. He expects inflation to be 4% – double the Bank’s target – by Christmas.

Here he warns of bigger problems, in that companies have developed “a dependency culture around cheap money” and that the threat of a rapid increase in prices is “rising fast”.

Red alert

Inflation can pose a real and present danger to institutional investors. When inflation rises by more than expected, it reduces the current value of the future flow of earnings by eating into fixed income yields and outstripping the dividends paid by equities.

Bonds are obviously in the firing line here. Their fixed stream of interest payments become less valuable as the overall cost of goods and services accelerates, sending yields higher and bond prices lower to compensate.

For investors, there may well be within this a big warning that the era of ultra-low interest rates may be over. And as central banks raise rates to address inflation, bond yields will follow and bond prices will fall, inflicting losses on investors.

This could be important for defined contribution scheme members, where the fundamental issue is with fixed-interest bonds, which currently yield very little and will result in big losses in a more inflationary environment.

Buying protection

Inflation though can be good for holders of assets if their values rise faster than the general level of inflation. This is an area of concern. Indeed, analysis has shown that when inflation is high and rising, equities beat inflation only 48% of the time.

Here it is interesting to note that commodities and real estate have offered more consistent protection in such an environment, beating inflation 83% and 67% of the time, respectively. But this has come at the expense of more volatile returns.

Index-linked securities could be added to that list, as, like the others, they do not offer a perfect inflation hedge, but do offer an element of portfolio protection.

Inflation could well be bad news for liability-driven investing, exposing deficiencies in the approach. While liability matching offers hedges against inflation, the proofing against it in defined benefit schemes is usually capped in the region of 3% and 5%. And if inflation exceeds these rates, the pension pot will suffer.

It also raises arguments about growth versus value: with value investing gaining ground relative to growth because with higher interest rates the value of growth companies’ earnings falls. The threat of inflation means investors have much to ponder.

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