How long will high inflation last?

Fred Demers & Brittany Baumann share their views on temporary inflation drivers and how to position institutional portfolios for what's ahead.
August 2021
Fred Demers

Fred Demers

Director, Multi-Asset Solutions
Brittany Baumann

Brittany Baumann

Senior Analyst Multi Asset Solutions

Fred Demers, Director, Multi-Asset Solutions, BMO Global Asset Management, and Brittany Baumann, Senior Analyst, Multi-Asset Solutions, share their views on the temporary drivers of inflation, and how to position institutional portfolios for what lies ahead – reminding investors that no two cycles are the same.

Normalization process already underway

After unprecedented increases in monetary and fiscal stimulus over a short amount of time, and growing supply shortages, fears over sustained high inflation (well above 3%) have no doubt increased. Are they indicative of what’s to come? We believe not.

What we’re seeing is the combination of the base effect and pent-up demand being unleashed all at once – a transitory outcome. If investors think back to March 2020, and companies shutting down production of all discretionary goods, people were still rushing to buy toys of all kinds, which is typically the first item that sees a significant dip in demand during a recession. That in itself is a strong argument behind the current transitory nature of inflation.

The bigger story, however, is not forgetting that life is already starting to normalize, and that when the dust settles next year, the base effect will likely shift in the opposite direction. While we will likely not face an economic slowdown, we should return to a cruising altitude, and some of that pressure from the demand side will therefore abate. Retail sales in the US have been strong because people were not spending on airplanes, or hotels, but rather on goods they could use like iPads and tools to renovate homes. However, this is all beginning to change with restaurants and travel reopening (granted at a different pace depending on where you live in the world), so we are moving in the right direction, and in the next 12 months, we will likely see a return to normal, particularly at the economic level.

The temporary driving factors of inflation

Currently, there are three main drivers of inflation, which are all temporary in nature: fiscal stimulus, the economic reopening and supply bottlenecks. The question is – how long will they continue being key driving factors? On the stimulus side, we know that it actually it peaked in the second quarter in the U.S., and while it is still running strong, unemployment benefits are now set to cease completely as of September. As a result, we can expect potentially more normalization in the labour market in the third or fourth quarter. Meanwhile, reopening is ongoing right now and at full steam in the U.S., while Canada and Europe are catching up to this pace. With regards to the supply side of the equation, this is likely the most uncertain factor right now. However, even here, it is important to flag that these bottlenecks have been caused by excessive demand, which on the back of fading stimulus, should normalize as well, particularly over the next 6-12 months.

Another source of inflation we’re seeing right now is rising wages, which could arguably be one of the key concerns moving forward. However, it is currently a direct result of the fact that while there is significant labour demand, it has not met by sufficient supply, and wages have been pushed up more than anticipated in recent months. Is this a signal that it will drive a so-called wage spiral and continue into next year? We do not believe so, since unemployment benefits are a big factor behind the slow recovery of the labour market. Once they end, we can expect more meaningful job growth – and that additional supply will weigh on wages going forward.

Most importantly, long-lasting trends that have weighed on inflation in the past are unlikely to be fully reversed. After full employment is reached, attention will again turn to the constraining structural factors present during the pre-COVID-19 economic expansion, from aging demographics and weak productivity to technological disruption and e-commerce.

When it comes to the tapering discussion, we believe the Federal Reserve (the Fed) wants to minimize existing anxiety and avoid a repeat “taper tantrum.” At the end of the day, the economic recovery has been better-than-expected, so the consensus is that the tsunami of liquidity will gradually ease, because that is the rational response to an improving economy. However, the stimulus is still massively supportive of markets, so it will be an extremely careful process and the Fed likely has a more balanced response in mind due to inflation fears that shook markets earlier this year. The fact is there are still millions of unemployed people in the U.S. as a result of COVID-19, and the central bank will need to see that resolved before any significant tapering is actioned. Even though the economy and stock markets have reached pre-COVID-19 levels, we are still behind in the labour market.

Pandemic price adjustments driving inflation

Core CPI versus Core CPI excluding COVID factors

Source: Bloomberg, January 31, 2016 – June 30, 2021.

Portfolio positioning: Time to think about quality and growth

So, what does this mean for institutional investors? While there may be a little more mileage left in the recovery phase, this has been an unusual recession where we’ve received an unprecedented wave of liquidity. Therefore, we think the next 6-12 months will be about transitioning toward mid-cycle positioning.

Despite some uncertainty about when that point is reached, this is clearly the direction we are headed, whether it is by the fall, winter or next spring. There is no ambiguity based on the faster-than-expected rebound in economic activity. As a result, we remain bullish on equities: however, it will be about the mix and differentiation going forward, including more selective positioning into defensive and growth-oriented assets. Undeniably, we are also in a high inflationary environment, so while we still believe it is transitory, selecting companies in areas geared to pricing power, resilient margins and stronger growth and earnings remains essential.

In terms of that tilt towards quality, U.S. equities appear more attractive, particularly in the tech sector, despite peak growth in the U.S. itself. Increasing technology adoption and the transition into the new economy are long secular trends, and while they may be operating in the fast lane because of COVID-19, these trends won’t peak anytime soon. Tech typically outperforms in inflationary environments, and coupled with robust earnings revisions, it remains a strong play this year. The Canadian banking sector is also ideal because even though they may trade cyclically sometimes, they are resilient, dividend-yielding companies.

Certainly, the wage pressures and more limited pricing power provide a case against the small-cap space in general, where we could see some headwinds moving forward, but the global re-opening dynamics and above-trend growth still offers upside to the sector. Recently, these stocks have also lagged behind in terms of the strong catch-up performance seen elsewhere in markets, and with the scope for rotating toward a more subtle growth environment (with higher-than-average inflation than previously), there is anxiety around the resilience of their balance sheets.

Across regional equity markets, global reflation is driven by the U.S. while Europe should join the recovery trail into 2022 whereas China has made the most progress toward normalization of economic activity. Our biggest concern in China is not about cooling growth, which is widely expected, but the negative policy stance against some of its tech companies, which puts a negative premium over the sector. Longer term, emerging markets equities stand out given their large footprint in global supply chains and should continue to benefit from the above-trend growth into 2022 and their stronger demographic outlook. While it’s clear the pandemic is far from over and continues to inflict an elevated health cost, we think the progression of variants will nevertheless have a lower and manageable economic cost in the future, as the global vaccination campaign continues.

No two cycles are the same

Ultimately, it has been a short, atypical cycle and that is why institutional investors are required to be more open-minded about the nature of the macroeconomic environment. Normally, we could have argued that the recovery phase would last for two years, but it has been barely a year and it is already time to think about moving on. No two cycles are identical, and this is quite a unique backdrop we are living in today.

What we can expect, with supply and demand normalizing, is the end of the stagflation debate. Interestingly, we will likely be facing the same functional headwinds we’re facing now – only reversed next year. In 2021, the reopening provides a very strong comparison point, and while there may be some moderation in certain sectors, we don’t believe prices will necessarily come down—they rarely do–unless demand collapses. As a result, in 12 months from now when the dust settles, it would not be surprising to see inflation hovering close to 2% or lower.

Disclosures

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