- 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.
Table 1: Monthly U.S. Inflation Readings above 2% (Share of Total, %):
Core CPI: Goods
Core CPI: Services
Source: Haver, BMO GAM. Monthly data since 1958. As of February 2021.
- 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.
- 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.
Still fear inflation?
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.