Inflation: up, up and away?

Key points:

• Relatively swift economic recovery looks likely
• Pent-up demand and fiscal programmes fuelling higher inflation forecasts
• Projected UK, Europe and US headline inflation may be one percentage point higher this year than last
• US, eurozone and UK central banks set to keep rates on hold this year and next
• Portfolio diversification is key to weathering inflation while protecting wealth.

A shockwave has reverberated through financial markets since February as the unleashing of pent-up demand, overwhelming fiscal support and surging commodity prices prompted economists to hike inflation forecasts. Similarly, government bond yields have climbed as investors revaluated central banks’ commitment to maintaining interest rates at historically low levels for a prolonged period.

It may be time for investors to gauge if persistently rising prices might force rate hikes and consider the need to adjust portfolios to mitigate the risk.

Stronger recovery hopes

The administering of vaccines around much of the world has accelerated the timeframe for the normalisation of activity. The vaccine rollout promises fewer new infections and lifts chances of a revival in service industries and eventually employment prospects.

We now project that the global economy will grow at 6.4% this year, up from a 5.6% forecast in January.

Building inflationary pressures

Governments are turning on the spending taps in response to the pandemic, fuelling inflationary pressures. The International Monetary Fund estimated in January that governments have committed $14tn to saving lives and livelihoods.

President Biden’s $1.9tn relief bill, passed in March and the second largest US stimulus package, includes direct cheques to consumers, extension of unemployment benefits and funds for vaccination distribution programmes. The aid should temporarily supplement income and government spending while the economy is weighed down by the pandemic.

Focus on commodities

Commodity prices form a high weighting in consumer price indexes and can quickly influence inflation forecasts. The anticipated recovery, infrastructure investment and climate change initiatives are pushing energy, metal and agricultural prices higher.

The total return on the Bloomberg Commodity Index is 34% over the past year. Investment houses increasingly predict a commodities supercycle is on the way. If commodity prices maintain their upward trajectory they would push prices higher, particularly in countries that have to import vast amounts of raw materials.

Are pricing pressures temporary or sustainable?

Given the broad range of inflationary pressures, it’s perhaps no surprise that year-on-year inflation may significantly rise this year in the UK, Europe and US.

That said, some factors suggest that the inflationary pressure being seen is transitory. Unemployment rates are elevated, compared to pre-pandemic levels, yet the wage growth often associated with core inflationary pressures has not being seen. The rapid digitisation and investment in technology may keep wage growth muted, even when labour markets recover.

The arresting of the coronavirus outbreak is far from assured. Unknown vaccine efficacy levels against future variants could also affect the recovery and, in turn, price pressures.

Short-term inflation forecasts

Barclays forecasts that the US Federal Reserve’s (Fed) preferred domestic inflation level, the core personal consumption expenditures (PCE) index, will hit 2.2% in the second quarter, easing to 1.8% in the third quarter and 1.9% in the fourth, then averaging 1.8% next year.

European inflation forecasts have risen, but weak underlying consumer prices pressure is expected to keep inflation subdued in the medium term. The euro area CPI will likely average 1.5% this year and drop to 1.1% in 2022. Meanwhile, our projections are for UK CPI to average 1.9% this year and 1.8% next.

Are rate hikes on the way?

The impact of stronger inflationary pressures on monetary policy is likely to be more muted than this year’s increase in bond yields suggest. This is due to inflation forecasts remaining below central banks’ mandated levels. We expect that the Fed, European Central Bank and Bank of England will keep rates on hold this year and next.

Wealth preservation and inflation

In order to preserve the long-term purchasing power of their wealth, investors need to generate a return that is equal to or preferably higher than inflation. However, even moderate price rises can start to cause meaningful damage to wealth preservation assumptions. For those seeking protection, there are a wide range of options available to mitigate inflation risk by using equities, fixed income and precious metals.

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