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Inflation outlook – 5 concerns

27 November 2020

Inflation is a primary risk to financial plans, particularly during a client’s decumulation stage. John Calverley, chief economist of newly launched investment support firm Tricio Investment Advisors, believes there are five reasons why we should be worried about inflation.

This article was first published ion the December issue of Professional Paraplanner.

Inflation has fallen this year and even in 2018-19, at the peak of the last economic upswing was mostly below the 2% target. But looking ahead, here are five reasons for worrying, not about a return to 1970’s style double-digit inflation but a clear move back above the 2% targets and potentially touching 3% or more. This suggests risks for conventional bonds and favours inflation-indexed bonds and real assets including property. Most stocks should do fine as long as inflation does not get out of control provoking a sharp tightening of policy.

A quick bounce back in activity

There is a strong chance that over the next 6-9 months vaccines will bring most social distancing and lockdowns to an end. If that happens economic activity could roar back to end-2019 levels and beyond, as people go out and spend and socialise. A rapid return to full employment and output will once again raise inflation risks.

Fast money growth

In the UK money supply M4 is up 12% this year, while in the US it is up an astonishing 24%. Quantitative easing is one reason but the main cause is a surge in precautionary borrowing by companies. For now, companies are holding on to the cash but when Covid-19 is defeated, some of this overhang could be spent on hiring and investment, adding fuel to the recovery and potentially bringing inflation. Over the long run there is a clear relationship between money and inflation.

Dovish central banks

Official interest rates are very low everywhere and central banks are active with programmes to provide additional stimulus. That is all fine and desirable, for now, but there are signs that central banks will remain very dovish well into the upswing. In the US the Fed has switched to a new average inflation targeting regime. This is a specific promise to aim for inflation above 2% and a commitment that it will not necessarily want to tighten policy next time unemployment goes below 4%. The Bank of England is unlikely to formally adopt such a strategy but in reality that is what it did back in 2009-12 when inflation rose above 3% for a while. The danger is that if inflation moves to (say) 2.5-3% central banks will be slow to move against it.

High government deficits and debt

Historically, high government deficits and high ratios of debt to GDP have been associated with high inflation. Deficits will fall considerably when the economy fully recovers. But without further action to cut spending or raise taxes they will likely remain well above 2019 levels. In the UK ‘austerity’ is officially dead and the government’s ‘levelling up’ agenda points to increased spending. While there are murmurings of higher tax rates, changes are likely to be limited. Meanwhile US net government debt is likely to reach over 120% of GDP by the end of 2021 and the UK’s will be well over 100%. High government debt, as well as the higher levels of corporate and household debt emerging, will make society averse to higher interest rates and make central banks more cautious about raising them, again risking higher inflation.

Changing structural trends

Last but not least, a major factor behind the disinflation of the last 30 years was the opening of China to the world economy. That had the effect of depressing goods prices and holding down wages for low and mid-skilled employees in developed countries. But China’s wages are rising and pressures are increasing to reduce offshoring. Another major long-term trend is that both the West and China are ageing rapidly which is inflationary because the number of people working will fall relative to the number of people consuming.

Inflation has been on the retreat for 40 years but that trend may be due for a reversal. Investors should beware and paraplanners should be sure to take inflation risks into account in designing portfolios.

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