Inflation – friend or foe for investors?

There’s always uncertainty about inflation

Peaks in inflation typically come twelve to eighteen months after the cyclical peak in economic growth.  However, the lagging relationship is not hard-coded. There are many unstable factors at play. 

1. The “speed limit” of an economy can change from one cycle to the next   
2. External shocks to exchange rates and commodity prices can impact the growth-inflation relationship at any time 
3. Technology changes the system. Does automation subdue wages growth while also boosting productivity? Or does technology increase real wages and create demand-supply bottlenecks in key sectors (housing, services, etc). 

This uncertainty raises questions for policy makers and financial markets alike. 

Monetary policymakers (government central banks) set the interest rate in an attempt to keep medium-term inflation within what they define as normal bounds.  

If inflation is left to climb too high above these bounds, central banks will be forced to ratchet up the cost of borrowing through interest rates. Otherwise, producers lose their local production cost advantage and could close down, leading to recession.  

If inflation is left to slip too low below normal bounds, policymakers will need to slash interest rates. Otherwise, consumers may go on a spending strike because they think prices will keep falling. And this could lead to depression.   

A closer look at the US

The uncertainty about the relationship between economic growth and inflation doesn’t just keep central bankers awake at night. Financial markets worry too.  And they worry the most if central banks worry, stoking volatility in bond, equity and currency markets.   

Some commentators have been quick to highlight the risk that the US central bank may have left it too late to return deposit rates to normal levels.  They think the inflation genie has been let out of the bottle.   

The chart below shows that the US Federal Reserve (the nation’s central bank) has indeed kept the deposit rate below neutral levels.  But, as the information box on the chart shows, the Fed expects to increase the rate above its long-term normal rate by 2020. That’s five rate rises of 25 basis points between now and then.  So, we don’t think that the US Fed has been slow at all. It’s the bond market that has been slow. It seems to be only fully discounting two or three of these rate rises.  So, there is more yet to be priced in, which is bad news for bond market prices.   

But is it bad news for equity markets?

Normal inflation is good

To be clear, inflation at normal levels is a necessary and positive element in stable economic and financial systems. And Nutmeg, for one, is very pleased to see normal signs of inflation returning to the scene.  

We’ve already taken steps to protect Nutmeg customers’ portfolios from the full impact of higher bond yields (lower bond prices).  The parallel to this underweight in bond exposure is our overweight equity exposure.  Equity markets have an in-built hedge against normal levels of inflation. The chart below shows growth in real wages. Moderate increases benefit profitable companies because they can increase their productivity to offset the real wage rise.

A problem would arise if real wages were to grow too quickly. That would not only eat into company profit margins but cause central banks to raise interest rates more dramatically than they have signalled. At Nutmeg, we don’t see this as a likely outcome. Though we continue to watch the data as it evolves, we remain comfortable with our higher-than-normal exposure to equity markets. 

Risk warning

As with all investing, your capital is at risk. The value of your portfolio with Nutmeg can go down as well as up and you may get back less than you invest. Past performance is not a reliable indicator of future performance.