Inflation – return of the bogeyman?

With Halloween just around the corner, the spectre of inflation has begun to haunt major economies. But is there a reason for investors to be spooked?

Trick or Treat?

The answer may depend on whether or not it proves to be cyclical, a transitory period in the expansionary market recovery from coronavirus, or a structural ‘new normal’ that is here to stay.

If it is the former, then it is unlikely to cause major concerns and can even prove to be a positive treat through increased wages and the ability to reduce debts.

However, the latter, may be something of a cruel trick for savers. This is because long-term inflation can act as a ‘silent thief’ eroding savings, reducing purchasing power and diminishing investment returns.

Investors may have some difficult asset allocation decisions to make if they need to counteract inflationary pressure. The traditional switch to inflation linked bonds and commodities is likely to appeal to the more risk-averse, whereas others may feel equities provide the best chance of above inflation performance.

Shorter duration bonds can be less sensitive to any subsequent interest rate rises yet may not deliver sufficient returns in a low yield environment. Meanwhile, income investors also face uncertainty over dividend paying stocks which could be cut back if businesses face additional running costs.

Witch’s cauldron

So why is inflation rising? In reality, it has been a combination of factors. The pandemic has created a witch’s brew of inflationary pressure as government stimulus packages, supply bottlenecks, economic recovery and pent-up spending all contribute to rising prices.

As the chart below shows major economies have hit their highest inflation figures for many years (the US figure of 5.4% is from July 2021 and fell back slightly to 5.3% in August 2021).

Frightening for markets

Protracted inflation could be scary for markets if it leads to spiralling prices and lower consumer spending. The risk of growth within the economy being choked off by lower consumer sentiment brings with it the risk of higher unemployment.

Similarly, changes in monetary policy through increased interest rates would have a knock on impact to bond markets and increase sizeable national debt burdens, thereby potentially slowing the strong recovery from the pandemic.

Don’t be afraid of the bogeyman

After years of low inflation, a period slightly above central bank targets may be nothing to fear.

In fact, there can be winners with ‘value’ stocks likely to outperform ‘growth’ stocks that had been trading on inflated earnings potential. More established value stocks typically have stronger balance sheets and greater pricing power.

Diversification in asset allocation via real estate and commodities may also provide opportunities for investors due to the residual value these assets hold.

Ultimately, investors should be wary of inflation’s impact on their portfolio and investment goals, particularly those seeking an income in retirement who no longer have an inflation adjusted salary to live off. However, we are a long way off the runaway train of global inflation in the 1970s and 80s when US inflation peaked at 14.76%. ¹

In reality, a period of slightly higher inflation could help stimulate the economy and provide increased consumer demand. However, if prices continue to rise and consumer sentiment begins to shift, the situation may begin to change and Ronald Reagan’s famously nightmarish quote that ‘inflation is as violent as a mugger, as frightening as an armed robber and as deadly as a hit man’ could prove to be a Halloween portent.