The short answer is not right now, but potentially down the road. And I believe it’s less about how high inflation can go than it is about the portfolio implications of even moderately higher global inflation, which investors haven’t experienced for most of the past 30 years.
It may seem odd to talk about inflation these days. However, the substantial level of coordination between monetary and fiscal policymaking following the COVID-19 shock, with many central banks providing ample space for fiscal stimuli by buying up newly issued debt, has led to inflation coming up in many discussions with clients lately. A string of recent data releases has also helped put inflation risk back on some clients’ radars.
Nonetheless, I think it’s fair to say that many clients remain to be convinced that inflation poses a real threat to their investment portfolios, particularly because similar concerns were (incorrectly) raised in the wake of the 2008 global financial crisis (GFC). It’s kind of like the “boy who cried wolf” all over again. So should we be worried this time around? No and yes.
Short-term vs longer-term inflation
I believe today’s inflation outlook is balanced and that clients should at least be thinking about inflation, even if they don’t take any immediate action. In the near term, the inflation outlook is uncertain at this point, but probably biased to the downside given the severe shock to global demand caused by the COVID-induced lockdowns. Longer term, however (i.e., roughly the next 3 – 10 years), I see reasons why clients should begin to consider the potential implications of rising inflation, as even moderately higher inflation rates would be a marked change from the past few decades.
- First, as the global economy restarts and recovers, it is not clear how much of the supply side will reemerge unscathed from the COVID shock. Any increase in demand to previous levels that cannot be adequately met by any part of the still-damaged supply chain will likely lead to inflation.
- Second, the longer-term desire to shorten supply chains and move production closer to the end user will require that production move from the lowest-cost to higher-cost producers, which, by definition, would be inflationary. This dynamic would also, to some extent, strengthen the bargaining power of labor, helping to “bid up” its price in an economy.
- Third, global central-bank policies have shifted from a single, independent mandate of combating inflation toward targeting a broader set of objectives, including supporting (through bond purchases) the fiscal priorities of the government. In other words, central banks’ focus on inflation has necessarily been diluted.
Implications for client portfolios
I believe these trends have several important implications for client portfolios. It may be worth using this interim period — before inflation actually sets in — to assess what preparatory actions, if any, you should consider taking with respect to your portfolio.
For example, the historically negative correlation between equities and government bonds — the critical diversification relationship in many investors’ portfolios — would likely reverse and become positive in a world of upside inflation “surprises.” With regard to specific asset classes, it’s possible that even moderate rates of inflation would exceed the nominal yields on many fixed income instruments. If so, their real returns would turn negative, in which case many allocators would need a compelling “non-return-seeking” reason to keep them in their portfolios.
In addition, assets that can provide true “protection” against inflation are few and far between. For instance, many clients favor commodities as a potential inflation hedge, but I suspect this preference may be (incorrectly) extrapolating lessons from the past into the present and future. Yes, commodities are typically linked to inflation when global growth is driving both higher inflation and higher commodity prices. But if overall inflation is driven upward by rising costs for services, rather than for manufacturing, then commodities might lose much of their efficacy as an inflation hedge.
More to come
This is the first in my inflation “series” of blog posts based on recent client conversations. The next one in the series, due out in December 2020, will compare and contrast the post-GFC inflation concerns with today’s inflation worries.