A return to inflation after Coronavirus?

It's been a long time since investors have had to factor inflation into their decision-making. A combination of factors, including ageing populations, high debt and globalisation, have served to keep inflation low in spite of loose monetary policy. However, this may be about to change with a possible inflation wave as economies start to recover from the impact of Coronavirus.

Different economic activity can cause different types of inflation

Governments have heaped huge fiscal stimulus packages on top of low interest rates leaving plenty of liquidity sloshing round the global financial system. With economic recovery on top, there are mounting concerns that prices may march higher.

This ‘demand-pull’ inflation is one of the main types of inflation: more people have more money to spend on the same amount of goods and services. Such increased demand usually leads to an increase in prices.

The other main type of inflation - ‘cost-pull’ - is driven by the increased costs to produce goods and provide services.

Inflation after Coronavirus

The potential for increased inflation after Coronavirus is particularly true in the US, where stimulus packages have been higher and economic recovery is faster. In March, consumer prices rose by 0.6% over February, meaning that inflation 2021 growth to date is at a pace not seen since 2012. Petrol accounted for almost half of the increase but there were also worrying signs of higher prices, for now at least, across the economy.

There are also concerns in the US around cost-pull inflation, with reports of higher input prices by US companies. Manufacturing groups say prices of labour and raw materials are rising, forcing them to put up their prices. It is possible that the problems are transitory, caused by pandemic-related bottlenecks, but investors have started to contemplate an alternative reality where inflationary pressures start to take hold in 2021.

For the time being, this inflation forecast for 2021 is largely confined to the US. However, if inflation after the pandemic is persistent in the US, it may spread elsewhere.

An inflation wave and bonds

Expectations of rising inflation in 2021 are already being felt in the bond market. Inflation after the pandemic poses a greater threat to longer-dated and higher quality bonds. Inflation and the prospect of higher interest rates mean that the fixed cash flows typical of bonds are less valuable. Those bonds with fixed cash flows stretching out some way into the future are more vulnerable.

In general, higher quality bonds – such as those issued by developed market governments or blue-chip corporates – will also be more influenced by inflation expectations. For lower quality corporates, most of the risk is related to the performance of the company itself. With this in mind, yields have risen (and prices fallen) in longer-dated government bonds and higher quality corporate bonds since the start of the year in response to concerns around higher inflation in 2021.

There has also been rising demand for inflation-linked government bonds. The value of Treasury inflation protected securities (TIPS) and index-linked gilts will move in line with consumer prices. As such, they can be a good tool to trade inflation expectations. However, investors need to be wary of what is already in the price – TIPS won’t provide significant protection if they already reflect high inflation expectations.

An inflation wave and other assets

Higher economic growth tends to create demand for commodities, particularly energy and the raw materials used in construction. This is particularly true for inflation in 2021, where huge government spending programmes on green infrastructure are likely to create demand for specific materials, such as copper and lithium. Equally, investors tend to turn to raw materials when they want inflation protection in their portfolio, so this can provide a tailwind for prices.

There is also an impact on the price of shares. An era of low interest rates naturally favours companies with high and enduring cash flows. If investors can only get 0.5% on a 10-year bond, a technology company’s 50%+ annual growth looks very appealing. However, if inflation expectations rise, those cash flows look less appealing and investors may become more discerning on how much they pay for them.

This explains the priorities of investors since the Coronavirus vaccine announcements in November last year. Undervalued economically-sensitive companies have recovered, while highly valued technology companies have been weaker. Banks have done well because higher interest rates tend to allow banks to improve their margins, while natural resources groups have benefited from higher commodity prices.

The role of central banks during an inflation wave

In normal circumstances, if we were to experience an inflation wave, central banks would move in and raise interest rates. However, they have made it clear that they are reluctant to do so in the short-term. The US Federal Reserve, for example, has said it will not raise rates until it believes economic growth is on a sure footing, looking beyond short-term bouts of inflation in 2021 if necessary. Other central banks around the world have also made it clear that they support a ‘lower for longer’ approach. As such, inflation could ‘run hot’ before central banks step in.

Inflation is an important influence on asset prices. As such, changing inflation expectations bring trading opportunities across financial markets. The Fineco platform allows you to trade inflation expectations dynamically, across a range of asset classes and 26 global markets with competitive and transparent pricing