Short of perhaps banks running out of money, nothing strikes fear in the heart of the financial world quite like runaway inflation. Images of children making kites out of banknotes, for instance, continue to traumatise German central bankers nearly a century on. “The best way to destroy the capitalist system [is] to debauch the currency,” observed British economist John Maynard Keynes in 1919 - a quote he attributes to Lenin.
Yet, over the last couple of years, most economies did not worry about inflation even as governments engaged in unprecedented fiscal and monetary expansion to resuscitate economies brought down by the pandemic. With the worst of the crisis over, investors now fear that the karmic retribution for indulging in “magic money” will soon fall upon them.
“It’s not quite the return of the Living Dead but the comeback of an almost forgotten relic from the past could haunt financial markets this year: inflation,” foresee Carsten Brzeski and James Knightly, global head of macro and chief international economist at ING respectively. They see headline inflation in the US and Eurozone overshooting to “levels last seen years ago” of 3% in 2Q2021–3Q2021 and 2% in 2H2021 respectively.
Most of this inflation is likely to stem from pent-up demand as deferred consumption and investment sputter back to life. Yet fiscal hawks and inflation worrywarts have also pointed to new fiscal stimulus — specifically, the Biden administration’s US$1.9 trillion ($2.6 trillion) package signed into law on March 12.
Harvard don Larry Summers calls the stimulus the least responsible US fiscal policy in four decades. “To take a potentially growing economy and to put on top of it US$1.9 trillion of stimulus is to take real chances [of inflation] of a kind that I don’t believe we need to take,” he says in a Bloomberg TV interview.
Will it or won’t it?
Meanwhile, markets are already on the move in response to these higher inflation expectations. Bond buying has resumed in earnest in anticipation of higher returns, with 10-year US Treasury yields rising from rock-bottom to slightly above 1.5% as of March 11. Equity investors are rotating away from tech-led growth stocks into cyclical plays which benefit from stronger inflation.
But are investors merely chasing shadows? “Right now, inflation is not a problem. It’s not likely to be a problem, whereas employment is a very real problem,” Commonwealth Financial Network CIO Brad McMillan tells Yahoo Finance Live. He was responding to Fed chairman Jerome Powell’s projection that inflation accompanying economic recovery will likely be short-lived. Yet inflation jitters have crept into the Fed’s Open Market Committee (FOMC), with four members in their recent meeting seeing a rate hike in 2022, compared to just one last December.
The Monetary Authority of Singapore (MAS), Singapore’s central bank, projects that core inflation in Singapore will gradually rise and turn positive in 2021. Still, inflation will remain well below its long-term average, with MAS maintaining a zero per cent per annum rate of appreciation on the S$NEER, a policy band it uses to control the Singapore Dollar against a basket of global currencies. The width of the band and the level where it is centred remain unchanged, MAS announced in its October 2020 Monetary Policy Statement.
“In terms of the upcoming April monetary policy review, we don’t expect that [MAS] will be in a hurry to recalibrate policy settings,” says Selena Ling, head of treasury research & strategy at Oversea-Chinese Bank Corporation (OCBC). MAS core inflation for 2021 is seen to average at around 0%–1% compared to –0.2% in 2020.
A strong onset of inflation would represent a marked departure from economic trends over the past decade. DBS chief economist Taimur Baig points out that inflation has been low for a very long time, with the Fed “undershooting its inflation target year after year” as global inflation rates followed a long-term downward trend. Inflation, says Insead economist Antonio Fatas, was last considered a real macroeconomic problem in the 1970s.
Disruption arising from the Covid-19 pandemic, moreover, means that the economy is now operating below full capacity. “Sustained inflation typically occurs after the economy is operating at full capacity and wage pressures take hold. The pandemic has dented output and demand, while unemployment … may remain elevated by longer-term standards,” says Marc Seidner, chief investment officer for non-traditional strategies at Pimco. The weak job market will also lead to muted wage growth in the medium term, mitigating further price increases.
It is therefore unlikely that additional fiscal stimulus will have worrying effects on inflation. IMF chief economist Gita Gopinath notes that even with the full amount of stimulus, US inflation will only be a manageable 2.25% in 2022. This is not far from the Fed’s target of “inflation moderately above 2% for some time” before considering any increases in interest rates.
Trusting the experts
Fed chairman Powell has insisted that there is no need to push back against rising treasury yields, describing present monetary policy as “appropriate”. Still, Oxford Economics’s chief global economist Innes McFee and lead economist Adam Slater have not ruled out a “taper tantrum” yet. Previous episodes of sharp yield hikes, they caution, have evolved from a “benign correction” to “a tantrum with wider consequences’’.
But Insead economist Antonio Fatas believes such hikes must be put into perspective. As sharp as the recent rise in bond yields have been, they have only returned to levels seen last January when Covid-19 was just beginning to spread. Even with liquidity sloshing in the wake of the GFC in 2008, inflation did not emerge as a significant economic challenge.
For now, the Fed’s conditions for a rate hike — full employment, actual inflation above 2% and inflation forecasts predicting inflation persistently above 2% — remain out of reach. “And yet the market continues to want to ‘test the Fed’s resolve’. Maybe once — just once the market will actually take Powell at his word,” complains an exasperated Jack Janasiewicz, senior vice-president at Natixis Advisors.
Fatas sees this distrust of central banks arising from a perception that central bank action is very risky. This view has been prominent since the GFC, when quantitative easing measures were seen as pumping “too much liquidity” into the economy. “None of the predictions coming from this narrative have been correct in the past twelve years,” he scoffs, noting also that a taper tantrum would likely run counter to the Fed’s desire for a swift recovery.
OCBC’s Ling does not see many central banks tightening monetary policy even as they turn less dovish. The European Central Bank is frontloading asset purchases, while the Bank of Japan introduced a marginally wider +/–25 basis points (previously +/–20) corridor around its 0% government bond yield target. Inflation is seen to remain below central bank expectations in all Asian economies, says Priyanka Kishore, head of India and Southeast Asia Economics at Oxford Economics.
“The inflation genie may have been put back into its bottle for the weekend, but someone is sure to pick it up and uncork it again soon,” cautions Jeffrey Halley, senior market analyst, Asia Pacific, OANDA. But having risen “too far, too fast”, however, Seidner of Pimco believes that rates may not have far left to climb, with OCBC’s Ling noting that inflation numbers could be inflated due to low base effects.
Riding reflation
In response to rising inflation expectations, Tim Murray, capital markets strategist in the multi-asset division at T. Rowe Price, reckons that investors should orient their portfolios to ride the expected rise in consumer spending. He favours assets such as value, smallcap and emerging market (EM) equities. Eli Lee, Bank of Singapore’s head of investment strategy, is overweight on energy, financials, industrials, materials and real estate, as well as US and Asia ex-Japan stocks.
Sean Taylor, APAC chief investment officer, DWS, thinks investors should pay greater attention to fundamentals. The growth narrative was prevalent during “peak Covid-19”. Many tech stocks, for example, had weak fundamentals but outperformed nonetheless. Now that markets are no longer willing to pay such a high premium on future growth, having strong fundamentals will be back in vogue. Still, Brian Arcese, Portfolio Manager, Foord Asset Management, sees a good opportunity for investors to obtain long-term growth counters on the cheap.
For fixed income, Martin Dropkin, head of Asian fixed income at Fidelity International is constructive on Chinese government bonds, which have strong yields of 3.2% versus 1.7% for US yields. Taylor is bullish on corporate credit, with supply seen to shrink in 2021 despite supportive investor demand; Dropkin sees credit — especially high-yield Chinese credit — exhibiting attractive spreads.
But with US treasury yields rising, the investment case for riskier Emerging Market (EM) fixed income could weaken relative to Developed Market (DM) fixed income. Ling of OCBC anticipates more rotations from EMs to DMs if US Treasury yields continue to trend higher, though much of this depends on whether EM bond yields rise in tandem. Most of the US$110 billion inflow into global markets year to March 17 2021 have been into DMs (US$92 billion), with a net withdrawal of funds from EM bonds except in EM Asia, which Taylor favours due to the latter’s more stable macro-environment.
In the currency space, Vasu Menon, OCBC’s executive director, investment strategy, sees a shift from recovery-centric drivers to yieldbased arguments. The US Dollar (USD) could benefit from safe-haven demand arising from market turbulence, as well as from a possible positive turn in currently negative US real interest rates.
Still, Menon notes that Fed cautiousness despite the Biden administration’s fiscal stimulus has cast doubts over the US’s ability to lead a recovery, with rising risk appetite from vaccination successes further weighing on the greenback. Cyclical currencies like the Australian and Canadian Dollars tied to economic recovery are seen to be more resilient than USD.
“We found that during a high inflation backdrop, commodities, especially oil, are the best hedge. They have the best track record in the past 100 years to protect you from unanticipated inflation — one that’s driven by scarcity of goods and services, and even wage inflation like that in the late 60s,” says Christian Mueller-Glissmann, managing director for portfolio strategy and asset allocation at Goldman Sachs. Non-yield commodities like gold are likely to see reduced upside from the rising bond yields, says Menon.
