Inflation is the word of the year so far in financial markets. There seems to be a major news item daily on the subject, including this morning’s data showing the highest yearly consumer prices increase since 2008. While it is still unclear if inflation will be higher than current market expectations over the coming years, today we want to cover how we at GGS are thinking about inflation and positioning client portfolios for this possibility.
First, let’s look at current market expectations for inflation.
- The expected future US inflation rate for the next ten years is now 2.5%, the highest the measure has been since 2013. It has been rising steadily since hitting its low of roughly 0.5% in March 2020.1
- The median expected US inflation rate for the next year is 3.4%, also the highest since 2013.2
Key takeaway: Investors are currently expecting higher near-term and long-term inflation levels than anything we have experienced in the past eight years. This is already priced into financial assets. What matters for asset prices going forward is how inflation rates evolve versus these current expectations.
Main arguments for and against higher inflation:
Near-term, the rapid reopening of the global economy, significant government stimulus, and pandemic-related supply-chain disruptions have led to near-term demand running higher than near-term supply in multiple major economic sectors. This is a recipe for higher prices and is the primary reason inflation expectations for the next year are so high, along with year-over-year comparisons to an economy in lockdown. However, these supply shortages, reopening/stimulus-driven demand, and skewed annual comparisons are viewed as temporary, so even if near-term inflation readings come in higher than investor expectations, markets may not react very much.
Long-term, we believe these are the two main arguments for higher inflation:
- Political/Federal Reserve messaging: Some analysts believe there has been a political shift in favor of higher inflation as a way to combat record high government debt levels. In general, inflation is good for debtors as the money they eventually return is not as valuable as the money they receive now. The Federal Reserve has also recently relaxed its stance from explicitly targeting 2.0% inflation to targeting a 2.0% inflation average, thus allowing inflation to temporarily rise above 2.0% given it has spent so much time recently under 2.0%.
- Aging demographics/deglobalization: The last 40 years have seen a huge expansion of the global labor workforce from demographics (number of working-age adults), the entrance of women into the workforce, and increased globalization. The global labor workforce will now likely be shrinking for the next 40 years due to aging demographics and recent deglobalization forces, which should increase labor’s power to demand higher wages, leading to higher inflation.3
Yet, there are also two main counter-balancing forces against higher inflation:
- Continued automation and technological progress that increases productivity and decreases labor’s bargaining power versus machines.
- A weaker than expected economic recovery going forward: Since 2010, many investors have been afraid of pending inflation following the large expansion of the Federal Reserve’s balance sheet from its Quantitative Easing program. Those investors thus far have experienced “Waiting for Godot” as global crises have helped keep demand-led inflation at bay (European sovereign debt/Euro-collapse fears of 2010-2013, Chinese economic growth worries in 2015-2016, global trade war of 2017-present, COVID-19 pandemic of 2020-present).4 In short, an inflation boom sparked primarily by continued significant economic demand growth requires a lot to go right.
Implications for GGS portfolio management
At GGS, our research focus is on finding high quality, undervalued companies and building clients a properly diversified portfolio. We do not focus our research on whether future market inflation (and by extension, interest rate) expectations are too high or too low, and thus we are not placing a significant bet one way or the other in client portfolios. We are aware of which sectors and asset classes do best when inflation/interest rates are rising (banks, cyclical/commodity industries) and which do worst (long-duration bonds, bond-like equities, high growth stocks). We own both of these groups in client portfolios and will continue to own both. Our focus is on managing inflation/interest rate exposure at the aggregate portfolio level and maintaining roughly the same exposure as our benchmark. We believe that our stock picking and disciplined portfolio/risk management are the key drivers of long-term success for our clients, not trying to make a significant bet on market timing, interest rates, or inflation.
3 Bernstein Research. Inflation and the Shape of Portfolios. May 6, 2021.
4 JPMorgan Research. Positioning for Inflation. May 5, 2021.