How should investors react to inflation?
Inflation has started to rise as the global economic recovery accelerates.
But we think the spike in inflation will prove temporary, and we expect central banks to keep policy rates on hold. For investors, a period of higher inflation and stilllow rates will mean even more deeply negative real interest rates on cash. This increases the incentive to put excess cash to work.
Inflation rates have been on the rise as economies rebound from the pandemic.
• The US ISM measure of prices paid by manufacturers rose to 89.6 in April, from
85.6 in March and 82.1 in January.
• The US consumer price index registered the largest monthly gain in March since 2012, while annual inflation hit 2.6%.
• Major economies are entering the reflation phase of the recovery in 2Q, during which growth and inflation both should increase.
But while the spike in inflation should be temporary, negative real rates will remain a drag on cash savings.
• Concerns that US fiscal stimulus could spark persistent inflation appear overstated, in our view. Federal Reserve Chair Jerome Powell has noted that there is plenty of hidden slack in the US economy, and in April he said that the Fed was “a long way” from its goals.
• The Fed’s latest “dot plot” showed the median expectation was for no increase in official rates until at least 2024.
• With Fed rates pegged close to zero and inflation still positive, negative real rates will make cash holdings a drag on returns. So investors have a strong incentive to put excess cash to work.
• In a low-rate, rising-inflation, high-stimulus environment, investors looking to protect and grow their real wealth will need to put their excess cash to work.
• We retain a positive view of equity markets and recommend using volatility to add exposure. Regionally, we prefer emerging markets.
• We expect the “hunt for yield” to be supportive of riskier credit segments. We have a preference US high yield bonds and US senior loans. For ex-US investors, we favor Asia high yield bonds.
New this week
The US labor report released on 7 May showed that the economy added 266,000 jobs in April—well below expectations—while the unemployment rate edged higher to 6.1%. Earlier in the week, Raphael Bostic, president of the Atlanta Fed, said that even a very high jobs number wouldn’t cause the FOMC to formally discuss reducing its monthly bond purchases of USD 120bn.
We expect any spike in inflation to be temporary, but investors should continue to put excess cash to work, as negative real interest rates will remain a persistent headwind.
• US fiscal and monetary policy remains expansive, with a USD 2tr infrastructure plan as well as the USD 1.8tr American Families Plan in the works. Meanwhile, the Fed will continue to buy USD 120bn of bonds per month, likely through year-end.
• At current interest rates, holding excess cash reduces your wealth, as inflation erodes its real purchasing power.
• Take the example of an investor with a USD 5mn portfolio and annual expenses of USD 250,000 that are rising by 2% each year due to inflation. Keeping the portfolio in cash would halve its value in just 10 years. Any further uptick in inflation would increase the erosion of real purchasing power. This is a problem for investors in the US and Europe, where real rates are all negative.
Investment view
We expect the near-term spike in inflation to be temporary and think central banks will keep rates on hold. A period of higher inflation and stilllow rates will mean even more deeply negative real interest rates on cash. So investors should stick to their financial plan and put cash to work.
Payroll shock
The labor report for April showed nonfarm payrolls increased by 266,000, far below consensus expectations of 1 million, and March was revised down to 770,000 from the previous estimate of 916,000. Bond yields fell and the dollar weakened after the release, while equity markets moved higher.
One point to keep in mind is that payrolls have a strong seasonal pattern, and economists almost always look at the data in seasonally adjusted terms.
However, given the unusual circumstances caused by the pandemic, the economy may not follow the usual seasonal pattern. In recent years, unadjusted payrolls have typically increased by around 1 million in April, which translates to around 200,000 after seasonal adjustment. In today’s report, unadjusted payrolls increased by 1.09 million.
With the pandemic ongoing and businesses struggling to find workers, it may just be difficult for payrolls to increase faster than that. Average hourly earnings jumped by 0.7% month-on-month and average weekly hours worked ticked up to match the record high of 35.0 hours, suggesting businesses are making other adjustments.
With payrolls still around 8 million below the prepandemic level, a slower pace of job growth could delay the timing of the Fed’s decision to taper until December.