Risk of high inflation beyond the near-term

A sudden rise in inflation is a key risk for any unprepared portfolio. Potentially, higher inflation could mean central banks tighten monetary policy in order to abide by their mandates. Inflation could also damage the economy by dampening consumer spending (70% of the US economy) through lower real wages or higher pre-cautionary savings on expectations of rising borrowing costs.

The good news is that the near term (~1 to 2 year) inflationary outlook across the globe looks benign. The impact of COVID-19 has hugely reduced demand, which will drag down underlying inflation. One way to observe this is through US real GDP growth and its lead on underlying inflation. With the consensus forecasting large GDP declines, US core (ex food/energy) consumer price inflation is expected to drop from its current position of around 2% to near zero in 2021 (chart 1)1. However, equity investors should not despair. From data going back to 1965, a 0-2% inflation range for each country has seen annual US S&P 500 and German DAX returns of 10.3% and 11.9%, respectively2. The UK FTSE All Share underperformed the other markets by returning 1.7% per annum during a 0-2% inflation range, though it outperformed as price rises accelerated.3

Chart 1: Lower demand to drag down US underlying inflation

Source: Refinitiv Datastream/Smith & Williamson Investment Management LLP, as at 1 May 2020

Nevertheless, the risk of higher inflation over the medium-term (3-5 years), primarily due to policy responses to COVID-19, has increased and is a risk for portfolios. We believe there are three driving forces of future inflation that investors need to be aware of. These are the expansion in the volume of money supply, the repair in household balance sheets from deleveraging and the effect of fiscal handouts. We look at each below and discuss how they differ from inflationary outlook following the Global Financial Crisis (GFC) in 2008. We focus on the US, where we see the risk of higher inflation is greatest.

#1) The volume of money supply: Central Banks and governments have injected record amounts of money into the global financial system to shore up struggling businesses and to maintain market liquidity. US broad M2 money supply (a measure of money flowing around the financial system including saving deposits and currency in circulation) is growing at 18%, its fastest rate since WWII (chart 2)4. This has been caused by policies to offset the economic effect of lockdowns, in particular Fed asset purchases (quantitative easing) and increased government-backed commercial bank loans.

Chart 2: Rapid growth in US broad money is a source of future inflation

Source: Refinitiv Datastream/Smith & Williamson Investment Management LLP, as at 1 May 2020

As any economics student will be quick to point out, an increase in money supply should, all things being equal, lead to inflation. Students looking for extra marks will remember the work of the great American economist Irving Fisher, and his equation of exchange:

Money Supply x Velocity of Money = Price Levels x Number of Transactions

What must not be understated here, is the importance of velocity, or more simply put, demand. The rate at which money circulates in an economy has the capacity to magnify the amount of money in that economy. Today, the M2 velocity of money (nominal GDP/M2 money supply) in the US is 1.43 and when combined with the 18% growth rate of money supply, suggests an inflation rate in the GDP deflator of 6.6% over the next 2 years if the US real economy were to expand by a 2% annually and the current rate of money supply growth was sustained5.

#2) The repair seen in household balance sheets from deleveraging: US households have deleveraged considerably over the last decade or so. Household debt as a share of personal disposable income has come down to 97% at the end of 2019 from a record 134% in 20075. This deleveraging should help consumption with less money being used to service debts. Moreover, household balance sheets are also highly liquid. The share of liquid assets (including cash, mutual fund shares and equities) to liabilities is 3.1 times, the highest level since 1972.6 These ratios suggest that household balances provide support for pent-up demand should consumer confidence recover, and unemployment begins to fall.

Chart 3: US households have significantly cut debt vs take-home pay

Source: Refinitiv Datastream/Smith & Williamson Investment Management LLP, as at 1 May 2020

#3) Fiscal handouts: Both the scale and scope of generous US fiscal handouts play a factor here. The US government passed a historic $2.3trn stimulus package and the Congressional Budget Office is estimating the 2020 US budget deficit to be 17.9%6.

Though the composition of the stimuli is probably a more important factor for future inflation. The US government’s CARES Act, gives an additional $1,200 per adult and $500 per child one-off payment. Moreover, the eligibility, duration and size of unemployment benefit schemes have increased in 3 ways. First, those previously ineligible, such as gig-economy workers, can now receive welfare payments. Second, the duration of benefits has risen. Individuals can now receive 39 weeks of benefits, rather than 26 previously, while those who had used up their standard 26-week benefit can now qualify for a further 13 weeks through to the end of July. And third, benefit payments have increased. All individuals can now get $600 per week from the Federal government through 31 July in addition to the nationwide average state unemployment payment of $370, to bring the total to around $4,200 per month. As the US election draws closer, the CARES act will become increasingly political and even be set to continue.7 The Democrats are looking to extend these extraordinary unemployment benefits.

There are significant differences between the bailouts today and during GFC, when governments last implemented significant policy stimulus. In 2008, the expansion in central bank balance sheets and government bailouts did not lead to consumer inflation. That’s because the money was used to recapitalise banking systems, which was disinflationary. The evolution of technology to keep prices down (think Amazon) and integration of China into the global economy system to boost the supply of goods also provided structural reasons for a further slowing in inflation.

However, fast forward to today and this ‘helicopter money’ gives cash straight to consumers, linking back to the idea of increased velocity. Consequently, in a recovery, especially if V-shaped where consumers return to their jobs quickly, there is pent-up demand ready to be unleashed and particularly as growth is being artificially supported by the government. Crucially, shoppers have money in their pockets to be spent from unemployment benefits and healthier balance sheets that could result in consumer inflation.

Increased inflation up to a point is not devastating to equities. But it is an important consideration in multi-asset portfolio construction. We look at how countries, styles and sectors perform in relation to US future inflation expectations. We find that emerging markets, UK, small cap companies, value stocks and some sectors, including energy and materials, tend to move positively to higher inflation8. Commodities, such as oil & gas, tend to see their prices move with inflation, due to demand inelasticity.

Chart 4: Inflation benefits EM, UK, small caps, value stocks and sectors such as energy and materials

Source: Bloomberg/Smith & Williamson Investment Management LLP, based on MSCI indices, data as at 31 March 2020.

In terms of fixed income, UK index-linked gilts and US Treasury Inflationary Protected Securities (TIPS) both protect against inflation. Our preference is for US TIPS which provide better value, as evidenced by lower breakeven rates of inflation (chart 5). In addition, TIPS are likely to be exposed to a greater source of inflation in the US, given the rapid growth in money supply.

Chart 5: US TIPS look cheaper than UK linkers as they have discounted less inflation

Source: Refinitiv Datastream/Smith & Williamson Investment Management LLP, as at 30 April 2020

Ultimately, the current downward pressure on demand will see extremely low levels of inflation in the near term. As demand returns, boosted by deleveraged households and fiscal handouts, we could see velocity combine with unprecedented level of money supply, which could well result in the return of inflation. As demand returns, boosted by deleveraged households and fiscal handouts, we will see velocity combine with unprecedented level of money supply, which may result in the return of inflation.

Please note specified government legislation is that prevailing at the time, is subject to change without notice and depends on individual circumstances

Sources:

1 Refinitiv Datastream/ Smith & Williamson Investment Management LLP 30/04/2020
2 Refinitiv Datastream, data since 1965, updated as at March 2020
3 Bloomberg/Smith & Williamson Investment Management LLP 30/04/2020
4 Refinitiv Datastream/ Smith & Williamson Investment Management LLP 30/04/2020
5 Bloomberg, as at March 2020
6 Refinitiv Datastream/ Smith & Williamson Investment Management LLP 30/04/2020
7 US Government, 30/04/2020
8 Refinitiv Datastream/ Smith & Williamson Investment Management LLP 30/04/2020
9 Goldman Sachs, April 2020
10 Refinitiv Datastream, data since 1965, updated as at March 2020
11 Bloomberg, based on MSCI indices, data since 2005
12 Refinitiv Datastream/ Smith & Williamson Investment Management LLP 30/04/2020

DISCLAIMER
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of writing.

Risk warning
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. This briefing does not constitute advice nor a recommendation relating to the acquisition or disposal of investments. While considerable care was taken to ensure the information contained within this article was accurate and up to date at the time of publication, no warranty is given as to the accuracy or completeness of the information.  No liability is accepted for any errors or omissions in such information, or any action or inaction taken on the basis of this publication.

Please remember investment involves risk. The value of investments and the income from them can fall as well as rise and investors may not receive back the original amount invested. Past performance is not a guide to future performance.
 
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