Inflation seems to be the name of the game when you looked at financial media recently. Central banks around the world are increasingly confronted with this question in light of the recent rapid rise in goods and services prices. To be sure, part of the marked rise in inflation in recent months can be explained by special effects such as higher commodity prices, disrupted supply chains and the economic recovery. Beyond this, however, several factors point to an increase in medium-term inflation risks.
First, change in the monetary policy reaction function. Many central banks have strategically reoriented their monetary policy – overshooting the inflation target is now explicitly or implicitly allowed. This increases the risk of monetary policy mistakes and of reacting too late to inflationary tendencies.
Second, excessive money supply growth and excess liquidity. The reference to a continuing low velocity of money in circulation does not hold water: empirically, no close correlation between velocity of money in circulation and inflation can be established.
Third, deglobalization and protectionism. The slowdown in the dynamics of international trade in goods and services due to the ongoing build-up of tariff and non-tariff trade barriers, as well as the national backshifting of parts of global supply and delivery chains, tend to have a price-driving effect.
Fourth, demographic change. Contrary to widespread opinion, inflationary impulses are likely to emanate from the demographic turnaround that has begun.
Fifth, tackling wealth and income inequality. An increased political focus on a more equitable distribution of wealth and income, as well as a consequent increase in redistribution and “big government”, could generate inflationary impulses.
Sixth, overheated real estate markets. The recent strong rise in house prices and overheating tendencies in real estate markets worldwide will also be reflected in the prices of goods and services in many countries with a lag of 12 to 18 months.
Seventh, fiscal and financial dominance. The steady rise in global public and private debt to record levels is not only reflected in heightened financial stability risks and fears of a debt spiral. In addition, debtors’ dependence on low interest rates and bond purchases by central banks as part of their quantitative easing measures has increased further. This harbours inflation potential in the medium to longer term.
Finally, combating climate change. Rising prices for carbondioxide and indirect inflation effects from a more sustainable orientation of global production processes should be reflected in higher goods prices.
All this shows: The risk of higher inflation rates in the medium term beyond current market expectations has increased significantly. Nevertheless, we believe that a renewed period of high inflation similar to that of the 1970s and 1980s is unlikely.
What does this mean for investors? A look at the past provides some initial indications, for which we have analysed the returns of various asset classes in times of rising inflation rates. Due to the broad availability of data, the focus was on the US. Our investigations lead to three findings.
First, a moderate inflation environment (two to four percent) has been ideal for equities in the past. On average, the annual performance of equities was in the double digits – adjusted for inflation! But bond markets have also generated solid real returns in these periods, in the mid-single digits. However, this result is influenced by the significantly higher interest rate level in the past.
Second, the attractiveness of equities declined in absolute terms and relative to bonds the higher the inflation rate rose. At inflation rates between four and six percent, equity performance was still positive and outperformed bond investments. At higher inflation rates, however, equities were often inferior to bonds and even lost value in absolute terms.
How can this be explained in economic terms? The result for the bond markets is obvious: rising inflation rates typically imply a higher nominal interest rate level (unless the real interest rate falls significantly) – bond prices fall. But higher inflation rates also weigh on equity markets, due to the dampening effect on economic activity: the higher inflation, the lower disposable income and thus private consumption. In addition, corporate margins and profits come under pressure. From mid-single-digit inflation rates, this is then also reflected in a valuation discount for equities.
Third, commodities, especially oil and industrial commodities, provided the most stable inflation protection. Interestingly, gold is only of limited use as an inflation hedge. As an “interest-free currency”, the gold price benefits from low real interest rates – high inflation rates may or may not be accompanied by low real returns.
What do these findings mean today? Provided that inflation rates – in line with our expectations – do not permanently rise above mid-single-digit levels, this suggests a preference for equities over fixed-income investments. However, an incipient normalization of monetary policy, especially in the US, could – at least temporarily – cause considerable unrest on the equity markets, especially as US equities in particular are extremely highly valued. Moreover, due to the extremely low level of interest rates, investors should expect negative inflation-adjusted returns in the event of inflation surprises.
Investors should also consider commodities, commodity equities and currencies of commodity-exporting countries. However, lower returns than in the past are to be expected in the event of inflation surprises, due to the recent sharp rise in commodity prices and the expected ongoing regulatory headwinds in the context of climate policy.
Finally, investors should in any case be prepared for a scenario of inflation rates in the medium term that are higher than previously anticipated by the market.