Beware inflation, which lurks before it spikes

Neil Dwane | 05/09/2018
Inflation

Summary

Investors shouldn’t get complacent about inflation: we may not see an early return to historic levels, but conditions are ripe for an unexpected rise. To fight the erosion of their purchasing power, investors should consider real assets – such as commodities and real estate – as well as equities and inflation-linked bonds.

Key takeaways

  • Inflation may be temporarily gone, but it should not be forgotten: oil prices, currency volatility and trade wars could force up inflation unexpectedly
  • The combination of inflationary factors and disinflationary structural forces – ageing demographics, a shrinking workforce – raises the risk of a policy error by central banks
  • When central banks see inflation, they will likely celebrate it rather than try to quash it like they did decades ago
  • Rather than debate what inflation’s true level is, or why it hasn’t reverted to historical norms, investors should question their own inflation complacency

Investors once knew to fear inflation, but it hasn’t been much of a factor for almost four decades – neither in the global economy nor in many investors’ strategies. This has led to a degree of happy complacency for consumers, who don’t like inflation because it means higher prices, and for investors, who haven’t felt the pressure to strive for higher real returns.

At the same time, central banks generally seek to maintain a certain level of inflation to keep their economies growing; recently, 2% per year has been their target rate. Yet in the post-financial-crisis era, central bankers have essentially printed money through policies of low rates and quantitative easing, and inflation has barely budged.

Working against inflation are certain disinflationary structural forces – such as ageing demographics and a shrinking global workforce – that show no signs of abating. Increased competition and the rise of the digital economy are also making it more difficult for companies to raise prices. These are worrisome developments that raise the risk of a policy error by central banks as they attempt to meet their inflation mandates.

Why inflation could move higher

Even though inflation may be temporarily gone, it should not be forgotten. We believe there are a range of reasons to expect that inflation could move higher unexpectedly:

  • The price of oil appears likely to continue hovering near USD 75 per barrel, which could be inflationary. An oil shock from the Middle East could drive prices up even more.
  • Diverging monetary policy among major central banks is causing currency-market volatility. For trade-reliant countries, weaker currencies mean import inflation, which can undermine real consumer spending and investment.
  • As China reforms its state-owned enterprises and the country begins exporting for profit rather than employment, higher traded-goods prices could help exporters but hurt consumers.
  • Trade wars will hopefully be short-lived, but friction between the US and China or others is likely to deliver a small increase to global inflation.
  • Asset prices have been boosted by “cheap” money and plenty of leverage, but the real-estate market could also cause problems if purchase and rental prices keep rising, consumer spending falls and economic inequality grows worse.
  • Businesses are faced with rising input costs from higher wages and increasingly expensive raw materials. Eventually, they may be forced to choose between lifting prices and reducing their margins.

Central banks are taking different approaches to inflation

The global economy made its way out of the 2007-2008 financial crisis by using record-low interest rates to pile on debt. A great deleveraging is overdue, yet much of the world’s debt may not be reduced by the usual measures – repayment or default – but instead repaid with “default by inflation”.

In this sense, central banks will likely celebrate inflation rather than try to quash it like they did decades ago. But since each economy faces a different set of threats and opportunities, investors should expect a variety of approaches from central banks managing diverging economies:

  • United States. The already strong economy could get even hotter thanks to aggressive fiscal stimulus in the form of President Donald Trump’s tax reforms. This could overly tighten labour markets and cause a boom-then-bust cycle, revealing a Federal Reserve that hasn’t raised rates quickly enough to keep up with inflation. Watch for the US dollar to move higher, and for a greater risk of higher wages, falling corporate margins and supply bottlenecks.
  • United Kingdom. With the UK mired in Brexit, the weakness of the British pound has pushed up domestic inflation – and with 60% of consumption coming from imports, the UK is vulnerable to more inflation shocks as Brexit unfolds. This could squeeze real consumer spending and GDP growth.
  • Europe. Excess production capacity, high unemployment and a strong euro have kept inflationary pressures low, and we don’t expect this to change even if Italy and France kick-start their economies.
  • China. Inflationary pressures have been modest as commodity prices stabilise and reforms in coal, power and steel work their way through the economy. Food prices are a political concern but have been contained for now, while a higher producer price index is supporting corporate profitability.
  • Japan. Japan remains mired in a modestly deflationary environment as the ageing of its society continues. Any changes to the Bank of Japan’s policy could leave the yen stronger and further contain inflation, even with higher oil and power prices.
  • Emerging markets. The inflationary outlook for Asia and other emerging-market nations is benign. However, a rising US dollar and higher oil prices may again constrain consumer spending and some corporate pricing power.

Core inflation may rise above the Fed’s 2% goal
Core PCE forecasts (2016 to 2019)

 

Source: US Bureau of Economic Analysis; Allianz Global Investors calculations Data as at 25/7/2018.

A strong link between low population growth and low inflation
OECD countries excluding Eastern Europe (2000 to 2016)

 

Source: Organisation for Economic Co-operation and Development. Data as at 31/12/2016. RSquared = 0.27.

What investors can do to fight inflation

Given the relative lack of inflation in recent years, too many investors may be neglecting to protect their portfolios. This is a mistake, given that even relatively low levels of inflation can significantly erode purchasing power over time.

To combat inflation, consider real assets like commodities and real estate, which have traditionally held their real value better than financial assets like bonds and cash:

  • While property has always been a good hedge, it is expensive in many regions, reducing its usefulness unless held for many years.
  • Infrastructure assets often provide the potential for attractive long-term returns, and they help institutional investors match long-term liabilities with long-term liabilities – albeit with now lower levels of yield.
  • Gold can be a hedge against both inflation and policy errors by central banks.

Aside from real assets, the two most common hedges against inflation are inflation-linked bonds (ILBs) and equities – though equities, like property, can be too volatile to be an effective inflation hedge in the short term.:

  • ILBs are markedly less liquid than many other fixed-income securities, and they can be expensive because large institutional investors buy and hold them to match their long-term liabilities.
  • What makes ILBs attractive is that they adjust for changing levels of inflation, offer much lower volatility and can provide a well-diversified global opportunity set – qualities that are particularly useful given the inability of many traditional fixed-income investments today to offer significant real returns.

Protecting purchasing power is paramount

Despite the debate about what inflation’s true level is, or why it hasn’t reverted to its historical norms, we believe the more important issue is investors who suffer from inflation complacency. Investors should aim to grow their wealth with the appropriate level of risk in a manner that protects their purchasing power against the longer-term threat of inflation – even at 2% levels. Sir John Templeton, one of history’s best-known investors, said it best:

“Invest for maximum total real return. This means the return on invested dollars after taxes and after inflation. This is the only rational objective for most long-term investors. Any investment strategy that fails to recognize the insidious effect of taxes and inflation fails to recognize the true nature of the investment environment and thus is severely handicapped.”

Investments in commodities may be affected by overall market movements, changes in interest rates, and other factors such as weather, disease, embargoes and international economic and political developments. Inflation-linked bonds (ILBs) issued by a government are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise.

Investing involves risk. The value of an investment and the income from it will fluctuate and investors may not get back the principal invested. Past performance is not indicative of future performance. This is a marketing communication. It is for informational purposes only. This document does not constitute investment advice or a recommendation to buy, sell or hold any security and shall not be deemed an offer to sell or a solicitation of an offer to buy any security. The views and opinions expressed herein, which are subject to change without notice, are those of the issuer or its affiliated companies at the time of publication. Certain data used are derived from various sources believed to be reliable, but the accuracy or completeness of the date is not guaranteed an no liability is assumed for any direct or consequential losses arising from their use. The duplication, publication, extraction or transmission of the contents, irrespective of the form, is not permitted. This material has not been reviewed by any regulatory authorities. In mainland China, it is used only as supporting material to the offshore investment products offered by commercial banks under the Qualified Domestic Institutional Investors scheme pursuant to applicable rules and regulations. This document is being distributed by the following Allianz Global Investors companies: Allianz Global Investors U.S. LLC, an investment adviser registered with the U.S. Securities and Exchange Commission; Allianz Global Investors GmbH, an investment company in Germany, authorized by the German Bundesanstalt für Finanzdienstleistungsaufsicht (BaFin); Allianz Global Investors Asia Pacific Ltd., licensed by the Hong Kong Securities and Futures Commission; Allianz Global Investors Singapore Ltd., regulated by the Monetary Authority of Singapore [Company Registration No. 199907169Z; Allianz Global Investors Japan Co., Ltd., registered in Japan as a Financial Instruments Business Operator [Registered No. The Director of Kanto Local Finance Bureau (Financial Instruments Business Operator), No. 424, Member of Japan Investment Advisers Association and Investment Trust Association, Japan]; and Allianz Global Investors Taiwan Ltd., licensed by Financial Supervisory Commission in Taiwan.

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Neil Dwane

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Global Strategist
Neil Dwane is a portfolio manager and the Global Strategist with Allianz Global Investors, which he joined in 2001. He coordinates and chairs the Global Policy Committee, which formulates the firm’s house view, leads the firm’s bi-annual Investment Forums and communicates the firm’s investment outlook through articles and press appearances. Neil is a member of AllianzGI’s Equity Investment Management Group. He previously worked at JP Morgan Investment Management as a UK and European specialist portfolio manager; at Fleming Investment Management; and at Kleinwort Benson Investment Management as an analyst and a fund manager. He has a B.A. in classics from Durham University and is a member of the Institute of Chartered Accountants.

6 takeaways from our London Investment Forum

Neil Dwane | 3 days ago
Neil Dwane addresses 2018 London Investment Forum

Summary

This September, our experts gathered to debate the state of the global economy and discuss how investors should approach the markets. Our consensus? The global economy is still doing fairly well, but politics and trade will drive markets in increasingly unexpected ways. Actively managing risks and opportunities – including diversifying among regions, asset classes and sectors – can help.

Key takeaways

  • Uncertainty and volatility are hallmarks of the global economic outlook; this is an opportunity for active managers to pick out the winners from the losers
  • Brexit and President Trump’s trade policies are adding to a climate of uncertainty, though the winners will become apparent in the longer term
  • Inequality is a genuine threat to economic and social stability, but there are many options open to companies willing to redress imbalances
  • Disruption through cyberattacks can damage returns, but engaging with companies can help assess their ability to handle cyber risks
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