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.
![Figure 1 plots monthly year-over-year U.S. and Canada inflation rates since 1940 until January 2021. Since 1990, inflation has been smoothly hovering around 2%, whereas the wartime era of the 1940s saw the highest surge in inflation, followed by the 2 episodes of high inflation in the 70s]](https://www.bmogam.com/ca-en/advisors/wp-content/uploads/2021/03/chart-1-2.png)
Source: Haver, BMO GAM, as of 10 March 2021.
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.
| 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:
The concern now, however, is that recent developments since the pandemic may reverse some of these structural drivers. Arguments for high inflation are:
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.
Source: Bloomberg, BMO GAM, as of 12 March 2021
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.
Source: Bloomberg, BMO GAM, as of 12 March 2021.
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.
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.
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