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The COVID-19 pandemic has led to huge social and economic upheaval globally. In March 2020, the US 10-year breakeven rate (the market-implied average inflation rate over the next decade) reached 0.55%, when the world was peering into a deflationary abyss. Fast forward a little over a year, and investors have flipped from fears of persistent deflation, to fears of persistent inflation at levels not seen since before the Global Financial Crisis.
The threat of sustained higher inflation not only has a potentially meaningful impact on our daily lives, but also has major implications for portfolio construction. To fully assess the impact of this we need to look at the reasons why the 10-year breakeven rate has now risen to 2.6%, but also consider why this rate may actually fall back, over our longer-term time horizon. In the short term, a little inflation is a positive thing for the global recovery.
We should however look at both scenarios in the context of wider risks to a multi-asset portfolio, not losing sight of the overall objective.
Following Aprils US CPI number of 4.2%, it is clear increasing prints will be the norm across the globe over the coming months, as the deflationary effects of the pandemic last year (oil actually briefly traded with a negative price in futures markets) affect the base for this year.
These base effects will be exacerbated by short-term supply issues, for example, shipping containers which are randomly scattered in ports across the globe, then there is the semiconductor shortage, which is hurting the auto industry, and even cardboard (think online shopping) boxes. To link it all together if you excuse the flippancy Cadburys owner Mondelez stated they cannot fill UK demand for their 99 flakes for soft-serve ice cream. It transpires the majority are made in a factory in Egypt, where until recently, a container ship literally blocked the Suez Canal.
There is an argument that if demand does bounce back sharply, supply will catch up, and thus any inflation surge will be temporary. However, US dollar weakness that has emerged in the last year will help inflation rise globally, coupled with the Feds new average inflation targeting framework which assists with inaction if inflation remains at higher levels, meaning that in the short-term investors need to be vigilant. We believe with our long-term perspective, structural trends weighing on inflation are unlikely to be reversed.
Demographics, debt, technology, output gap (may take years to close), labor mobility linking to anti-globalization are a few of the key disinflationary dynamics that face the world today.
To take demographics and debt as examples – fiscal stimulus is being utilized in this crisis, but most of it has been to replace consumption and investment impacted by the pandemic. Many economists argue that if debt is only used for consumption, then that simply brings forward consumption, weighing on consumption further out unless you can push debt higher and higher.
It is probable we will see low growth rates on count of aging demographics. US population growth in 2019 was the slowest since 1918 (even more remarkable as it was the year of the Spanish flu, and WWI) and unsurprisingly 2020 was even worse. Chinas recent census delivered a similar message, revealing the depth of the demographic challenge.
World population growth in 2019 was the slowest since 1952, and advanced economies outside the United States are at multi-decade lows. The combination of deteriorating demographics and the overuse of debt capital (studies appear to show evidence that higher debt levels push down on the velocity of money) are powerful disinflationary forces.
In terms of portfolio positioning, it is imperative to remain focused on the longer-term objective, but we must consider viable inflation insurance assets for part of the portfolio construction. As inflation rises above 3%, bond and equity correlation has historically turned positive. A key advantage of multi-asset investing is the ability to be flexible, and to access the widest opportunity set of asset classes.
For example, real assets like infrastructure and property look more attractive than index-linked bonds. Certain areas of the equity market can benefit too (even technology stronger pricing power and less debt), also commodities such as gold, plus silver and nickel due to demand (short and longer-term) from electronics, solar panels, EVs and the batteries used to power them.
In summary, inflation numbers in the near term will likely remain elevated. However, for the reasons discussed we believe over the medium to long-term inflation will subside from these levels. The uncertainty in the short term will no doubt create some volatility, which in turn may provide us with some attractive investment opportunities for the longer-term time is rarely an enemy. Different assets offer different levels of protection against higher inflation. Our challenge is to cut through the noise and identify those that do this best in the context of the wider portfolio.
Inflation is not the only risk investors should be considering, and thus building an all-weather multi-asset portfolio requires a disciplined process and creative philosophy, which enables us to search for and select the most optimal diversification of assets to take into account all risks, whilst being able to deliver our investment objective.
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