Pent-up demand, coupled with limited supply, has put upward pressure on prices. April’s year-over-year headline inflation number of 4.2% - the highest seen post-Financial crisis – is certainly unsettling on the surface. At 3%, core inflation was also larger than many have experienced. While largely expected for several reasons detailed below, inflation is likely to continue making headlines over the next few weeks, particularly as the May data is expected to come with another high print before settling down in June. While it’s uncomfortable to see a rapid surge in prices, the data suggests higher inflation is being driven by short-term forces. When it comes to investing, the longer-term forces carry greater importance and at this time we see more downward forces than upward pressure on long-term inflation.
Headline and Core Inflation
Source: Bloomberg, RBC GAM. Data as of May 12, 2021. YoY = year over year CPI data.
Why does inflation matter for markets?
Bond yields are partially driven by inflation expectations. Central banks like the U.S. Federal Reserve (Fed) have set explicit targets around the level of inflation that is expected for a properly functioning economy. When inflation begins to outpace the level targeted by central banks, they increase interest rates in order to slow down activity and prevent the economy from overheating.
However, the Fed has been very clear about wanting to see inflation sustainably rise above 2% before raising rates. After years of lackluster growth and low prevailing rates of inflation, they are being very conscientious about nourishing economic impulses, with the goal of spurring stronger growth in the future.
At the same time, investors see these higher prints and look for signals about the future trajectory of rates. They try to gauge not just when the first rate hike might occur, but also how quickly subsequent hikes will happen. These forecasts are reflected in market implied policy rates, a curve that shows the imbedded expectations at various points in the future. It’s interesting to note that while the 10-year yield rose about 6bps on the back of the strong April inflation number, expectations are actually slightly lower than they were at the end of March. Indeed, the 10-year yield now sits below its year-to-date high. This tells us that while the headline inflation number was slightly higher than consensus expectations, it was not a hugely surprising number and to some extent already considered in future rate assessments. At this point it seems investors are awaiting more information around whether this data is transitory or persistent.
Market expectations for rate hikes
Source: RBC GAM, Bloomberg. Data as of May 12, 2021. Based on market implied policy rates as of various dates.
Compared to fixed income, equities tend to offer better protection against inflation. This is because, in theory, companies should be able to grow their earnings and revenues at a rate that matches or exceeds inflation. However, interest rates are an important input into assessing the value of a company’s future cash flows. Through mid-May, the S&P 500 fell about 4% over a few short days. This was partly a reflection of investors taking some risk off the table in a market that was fairly exuberant. However, it was also a reflection of the growth premium that has been afforded to a number of companies, and how that premium might adjust in the face of higher rates. This is evident when we compare performance of the S&P 500 to that of the Nasdaq 100, which predominantly consists of high-growth technology businesses heavily valued on their future growth potential. While the S&P 500 dropped about 4% off its highs, the Nasdaq was down nearly double that rate. Why? Higher rates mean a lower terminal value on future cash flows, which demands a lower current price, all else equal. This makes companies that are valued on growth potential more sensitive to future rate expectations. It also disproportionately impacts the valuation of companies that pay out a large proportion of their earnings to shareholders given their more fixed income-like nature.
What is driving higher inflation?
In many ways, higher year-over-year inflation numbers were predictable. Last spring, in the midst of tight global lockdowns, a number of businesses were forced to shutter their doors and lay off millions of workers. April was also the month oil prices briefly went into negative territory. In the world of economics this is known as base effects. Today’s prices are that much higher because of the artificial lows that manifested one year earlier.
Beyond this, the ramifications of supply-chain issues that were brought on by the pandemic are still an issue. For example, the cost of lumber has jumped substantially, not because of a shortage of raw materials, but because slowed production at sawmills has meant less timber is being turned into lumber – all at a time when lumber is in higher demand. Prices adjust based on the forces of supply and demand. In this case, there is a shortage of supply and excess demand – enter inflation.
Similar dynamics have shown up in the market for used cars and in the tourism industry as activity around lodging and flights starts to come back. This was largely expected and broadly communicated. The important point underlying all of this is that these effects are transitory and should disappear as supply-chain issues begin to resolve themselves.
The medium-term and long-term outlook
When stretching our horizon out over the next couple of years, more inflationary pressures come into play. However, as Eric Lascelles, Chief Economist of RBC Global Asset Management has discussed, these are not likely to be permanent. For instance, the effects of economies reviving from the pandemic are likely to be inflationary. Meanwhile, output gaps exist and the level of economic slack remains plentiful. To this end, broad measures of unemployment remain elevated and significantly higher than official metrics. As such, it’s hard to argue for outright high inflation from a cyclical perspective.
Medium-term inflationary forces
The amount of money being printed by central banks is arguably the biggest inflationary risk. However, this risk is actually smaller than it appears. A majority of the money printed by the U.S. Federal Reserve has not made its way into the economy, and has instead been returned to the central bank in the form of additional reserves. In addition, we cannot forget that it is the goal of central banks to achieve a normal amount of inflation. They have every ability to course-correct, albeit at the cost of higher interest rates.
Looking toward the long-term picture, several downward structural forces are uncovered that are more likely to keep inflation in check. These include:
- Demographics: Slower population growth and an aging population should exert downward pressure on prices.
- Technology: The rate of technological progress should continue to increase productivity and will likely prove deflationary.
Long-term inflationary forces
All of this to say, consumers are undeniably facing rising inflation right now. But, many of these pressures are temporary. While inflation may be elevated over the next few months, it’s likely to run only moderately above 2% over the next few years. This is a bit higher than we’ve experienced in recent years, but it’s not truly high. Over the long run, there remains more downward pressure. This suggests that sustaining 2% inflation could be a challenge. As such, it’s little wonder why central bankers, the world’s leading experts on the subject, are largely unfazed by the prospect of too much inflation.
How can investors mitigate the risks associated with higher inflation?
The current environment certainly leaves investors with plenty to consider. It’s one of the reasons why evolving portfolios and closely monitoring their asset mix as market conditions change is now more important than ever.
- Fixed income investors are often enticed by the stable stream of income these holdings provide. However, this quality means the purchasing power associated with a bond’s future income (which is fixed in most cases) declines as inflation rises. These risks can be mitigated by holding bonds with a variety of characteristics including: shorter-maturity, higher risk, as well as looking globally for investments.
- Equities, meanwhile, tend to offer better protection against inflation. That said, certain pockets of the market are impacted more than others. The key for investors is diversification. Protection against higher levels of inflation can come from exposure to companies with ties to commodities, real estate, or those with the ability to pass on price increases to their customers without impacting demand.
Within the context of a balanced portfolio, protection against inflation tends to lead investors to add more equities at the expense of fixed income. In theory, equities offer more upside potential and have historically demonstrated an ability to generate returns that exceed inflation.
Yet equities can also lead to greater volatility – which can in turn make it harder for an investor to stick with their plan. For this reason, fixed income plays an important role within a diversified balanced portfolio. Used well, it can help create a smoother investment experience. The key is to choose these investments carefully, with deliberate strategies to address inflation.