Multi-Asset

Inflation Fears in a Post COVID-19 World

Fears of deflation have since morphed into fears of overheating after unprecedented increases in monetary and fiscal stimulus in a short amount of time and growing supply shortages.

March 2021

Fears of deflation have since morphed into fears of overheating after unprecedented increases in monetary and fiscal stimulus in a short amount of time and growing supply shortages. We agree that uncertainty over future inflation has increased. But the likelihood of prolonged periods of high inflation has not, in our view.
Long-lasting trends that have weighed on inflation are unlikely to be fully reversed. Most importantly, recent stimulus will not solve structurally low economic growth rates in 2022 and beyond. Also, the adoption of inflation-targeting central bank policy suggests a high bar for inflation expectations to become entrenched to the upside.
We outline several ways to hedge the coming pickup in inflation this year, which we view as temporary. These include tactical allocations to Treasury Inflation-Protected Securities (TIPS) and certain equity sectors and styles whereas regional exposures are less straightforward. Above all we recommend staying focused on longer term dynamics when positioning for a post COVID-19 world.

Inflation is caused by too much money chasing after too few goods.

Milton Friedman

Since the Global Financial Crisis, fears of deflation have dominated the minds of policymakers and investors. The focus has since turned toward the risk of inflation overheating following unprecedented increases in monetary and fiscal stimulus in a short amount of time. This suggest greater uncertainty over future inflation but not necessarily a greater likelihood of prolonged periods of high inflation.

First, how do we define inflation overheating? Generally, it is sustained increases in the inflation rate well above 3% coupled with market-based, firm and household expectations rising above 3%. Central banks would view these rates as uncomfortably above their inflation targets of 2% or target ranges, 1-3%.

High inflation occurred before the 1980s but has since slowed, averaging levels below 2% since the Global Financial Crisis (Figure 1). For example, before the 1990s, inflation was above 2% roughly 75% of the time; since 2008, less than half of the time inflation has run below 2% (Table 1). For example, before the 1990s, inflation was above 2% roughly 75% of the time; since 2008, less than half of the time inflation has run below 2% (Table 1). A big factor is goods prices (outside of food and energy), which have risen above 2% less than 10% of the time since 2009. Services prices have also slowed but not nearly by as much. This suggests that if stronger inflation is around the corner, it most likely will have to come from goods prices, which despite two commodity supercycles in the past two decades have failed to reflate. If not, services prices will have to rise significantly to offset the drag.

Table 1: Monthly U.S. Inflation Readings above 2% (Share of Total, %):

empty cell	Headline CPI	Core CPI	Core CPI: Goods	Core CPI: Services
Pre 1990	75%	79%	68%	95%
Since 1990	64%	68%	14%	91%
Since 2000	53%	53%	5%	86%
Since GFC	35%	37%	9%	76%

Source: Haver, BMO GAM. Monthly data since 1958. As of February 2021.

There are several factors contributing to low inflation:

Liberalized trade starting in the 1980s and culminating with China’s entry to the World Trade Organization (WTO) in 2001, which has lowered the cost of producing and importing goods.
Structurally lower economic growth thanks to aging demographics and lower productivity, which has lowered demand-pull inflation.
Under-estimated slack conditions and skill-biased mismatches in the labour market, which has weighed on wage growth.
A flatter Phillips’ curve, which shows a reduced response of inflation to output gaps.
Technological innovation and ecommerce, which has lowered prices of investment goods and made retail prices more competitive.
A lower labour share of income and reduced worker bargaining power, which has lowered wage growth.
Inflation-targeting central banks beginning in the 1990s, which have been effective in controlling household and market-based inflation expectations.

The concern now, however, is that recent developments since the pandemic may reverse some of these structural drivers. Arguments for high inflation are:

Countries are more open to reshoring production, and globalization has peaked.
Efforts to combat inequality like raising minimum wages and promoting unions are a higher priority, particularly in the U.S.
Pandemic-related supply shortages, indicated by soaring shipping costs and producer prices, may worsen as developed economies reopen. Supply-demand imbalances and surging commodity prices may suggest the early stages of a commodity supercycle.
Massive fiscal stimulus packages and ultra-low interest rates has allowed the money supply and savings rates to soar, pointing to significant pent-up demand to be unleashed, amplifying existing supply shortages.
What’s more, the Fed has adopted a new inflation targeting policy that tolerates higher inflation going forward, implying a later rate liftoff and lower for even longer rates. Should high inflation materialize, central banks may lack the tools to fight inflation thanks to high levels of household and corporate leverage, where raising rates would have more harmful consequences than in the past. The latter concern is a fair one.

We would argue that these developments are unlikely to fully reverse the long-established trends weighing on inflation, particularly those related to globalization, aging demographics, weak productivity, and technological change. Another reason is that inflation expectations are likely to remain anchored by inflation-targeting central banks barring a prolonged overshoot. Research shows that the response to realized inflation is low in household surveys, with a 1pp increase in inflation sustained over one year raising survey expectations by just 10bps.

A prolonged overshoot is also in doubt. Significant demand-pull inflation can materialize if consumers quickly spend all their savings this year, but this is unlikely. Slack conditions in the labour market will remain high this year, with the total job loss unlikely to be absorbed until 2022. In the U.S., the unemployment rate is about 3 percentage points higher than the headline rate of 6.2% as of February because of workers who have dropped out of the labour force. Fiscal stimulus, which has largely been transfer payments to households, suggest a speedier recovery but will have a one-off impact on economic growth, likely peaking in Q2 in the U.S. The next U.S. fiscal bill on infrastructure is a positive, albeit modest, boost to the long-term growth potential, i.e. raising the economy’s speed limit to deal with inflation. It implies much less of a front-loaded economic impact over the next few years, especially if corporate tax rates are raised. Finally, a sustained commodity upswing is unlikely to occur without sustained above-trend global growth that is especially reliant on China, where its share in industrial metals demand is greater than 50% and where demand is expected to moderate.

Despite heightened concerns, long-term expectations remain well-anchored in the fixed-income market. The inflation breakeven curve is currently inverted, meaning higher inflation expected in the next few years than further out (Figure 2). This likely reflects rising commodity prices and U.S. fiscal stimulus, both of which we do not expect to have lasting effects (Figure 3). At the same time, longer-term 5y5y forward, 10y and 30y breakeven inflation rates in the U.S., which are better measures of inflation expectations, remain near 2%. In Canada these rates remain below 2%. Surveys of household expectations tell a similar story—low with room for improvement.

Positioning implications

Higher inflation is not always bad for your portfolio. Equity returns are generally positive when inflation is rising and below 3%. Inflation rising sustainably above 3% will be a tall order to achieve. Indeed, stronger inflation is likely later this year as services prices recover and economies reopen. How fast consumers spend their savings, how quick the labour market recovers and the persistence of supply shortages will guide the pickup in inflation. But this trajectory is unlikely to de-anchor inflation expectations and result in a higher level of inflation going forward.

Importantly, recent fiscal stimulus do little to boost economic growth rates substantially in 2022 and beyond. After full employment is reached, the attention will again turn to the structural factors that weighed during the pre-COVID-19 economic expansion, e.g. low productivity, population aging, and technological disruption. Staying invested in equities, particularly in areas geared to pricing power, resilient margins, and stronger growth and earnings, remains key.

Still fear inflation?

Ahead of the likely pickup in inflation, economic reopening and a shower of fiscal stimulus this year, tactical positioning geared to the reflation trade remains attractive. To help shield fixed-income assets from positive inflation surprises, investors can overweight Treasury Inflation-Protected Securities (TIPS), such as BMO Short Term U.S. Treasury Bond Index ETF (ZTIP) and BMO Real Return Bond Index ETF (ZRR), with the former preferred to the latter given its shorter duration exposure. We currently have TIPS exposure in our Fixed Income ETF and SelectTrust Fixed Income portfolios.

Equities offer a wider spectrum of opportunities to benefit from a global reflationary impulse. Across equity sectors, energy and materials tend to outperform when prices for raw materials are running hot, like they are this year. To fund the overweight of these sectors, investors can tactically decrease their exposure to sectors such as consumer staples or utilities. We would highlight that information technology (IT) outperforms in inflationary environments. Coupled with robust earnings revisions, it remains an attractive play this year. Across equity styles, further strength in the reflationary impulse should see small-caps, cyclicals and value outperform growth, quality or low-vol equity factors.

Across regional equity markets, tactical opportunities are probably more subtle, especially after accounting for potential currency trends. Global reflation is driven by the U.S. and China, so these two regions should be the primary beneficiaries of their own economic outperformance. Emerging Markets (EM) equities traditionally stand out given their large footprint in global supply chains. While Japanese equities are well positioned for a global household consumption binge, the currency should be expected to be a significant drag, especially with the Bank of Japan’s monetary policy that limits the scope for interest rates to rise. For Canadian equities, the large weight to commodities is a positive, but its narrow focus on raw materials offers less opportunities to capture rising prices than having broad exposures to supply chains such as those of U.S., EM or Japanese markets. However, the Canadian Dollar would be expected to appreciate versus commodity consuming currencies such as the Japanese Yen or the Euro in a reflationary environment.

Finally, buying real assets that tend to beat inflation in the longer run is another example, such as BMO Global Infrastructure Index ETF (ZGI). Gold is the traditional inflation hedge and performs best during periods of stagflation compared to reflationary periods in a recovery.

Disclosures

This article is for information purposes. The information contained herein is not, and should not be construed as, investment, tax or legal advice to any party. Investments should be evaluated relative to the individual’s investment objectives and professional advice should be obtained with respect to any circumstance.

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