Risk of chronic inflation is the cloud to economic silver lining

Leading economic indicators continue to suggest, for the most part, that developed economies remain firmly in recovery mode, despite some variations. In the US, manufacturing and services indicators are comfortably in expansionary territory, consumer confidence has just recorded its biggest two-monthly gain on record, the housing market is robust, and first-quarter GDP printed an initial reading of 6.4% growth.

In the eurozone the purchasing managers’ index (PMI), seen as a key measure of the direction of economic trends in manufacturing, has risen to a three-year high of 56.9, driven by a jump in the services PMI to a 35-month high as reopenings bolstered activity. Hopes for an end to lockdowns in the US and Europe, together with ongoing stimulus measures, look set to continue to drive robust growth in the months ahead.

The recovery will be aided by pent-up demand fuelled by Covid-led savings and restocking of depleted inventory levels as manufacturing activity rebounds. This is all positive for corporate earnings and risk assets, but there are growing fears that the global economy will run too hot and core inflation will become embedded rather than transitory.

The latest US inflation data sent a shock wave through markets given the headline print of 4.2% (ahead of a forecast 3.6% and a substantial jump from 2.6% in the previous month). At the same time, inflation expectations have also increased to levels not experienced in more than a decade.

The initial reaction in developed government bond markets was negative, but perhaps not as pronounced as expected given the scale of the beat. Base effects are having a significant effect on inflation, but other factors such as high commodity prices, short-term supply bottlenecks across many industries and products, and even labour shortages in some sectors, have been important contributors to the rebound. 

How “sticky” inflation may become is now creating much debate. After years of consistently undershooting the US Federal Reserve’s 2% target, the current backdrop is certainly supportive of the “cost push, demand pull” dynamic that can keep inflation elevated for longer than wished for — an outcome that could prompt the US Fed and other central banks to rethink both their “transitory” (inflation) and “lower for longer” (interest rates) rhetoric.

Higher inflation tends to be associated with higher interest rates or a less supportive monetary backdrop. Risk asset valuations, such as equities and property, have significantly benefited from low interest rates and extraordinary supportive monetary and fiscal policies. In addition, cheap money and/or unattractive bond and cash yields have encouraged investors to embrace more risk to achieve a real return, and companies and households to expand their balance sheets as confidence levels improve. This in turn has provided support to asset prices such as house prices, shares and corporate debt, with positive spillover effects on individuals’ wealth and general economic activity.

An unwind, or even just a less supportive environment, will act as a drag on liquidity, money supply and economic growth and a headwind for asset prices.

A temporary spike in inflation would not be something to be overly concerned about as central banks and investors will look through it. But a sustained inflationary environment or, worse, higher inflation expectations, would prompt a response from central banks to stave off the negative effects associated with high inflation, such as reduced purchasing power, which tends to affect lower-income groups the most. In addition, holders of fixed (high) income stream securities such as bonds or high dividend income shares, stand to lose the most as higher inflation eats into their real income.

A combination of higher for longer inflation (which is certainly not a foregone conclusion and not our base case) and less monetary stimulus or higher interest rates, would be a headwind for risk asset valuations for several reasons. Higher (costs) inflation tends to squeeze the profit margins and profitability of companies and industries that don’t have pricing power. Higher operating costs combined with a higher cost of servicing debt, especially in the current environment of elevated debt metrics in the private sector after last year’s recessions, will be a double blow to the profitability of companies, with negative implications for the job market and real economy.

Another aspect for investors to consider is that higher interest rates have a negative effect on valuations as the discount rate used for valuing future cash flow streams increases. Shares that are most at risk from a valuation perspective are those with the lowest discount rates (cost of equity) and highest growth profiles, and perhaps explains the underperformance from these very popular and perhaps over-owned shares this year. Put plainly, higher inflation results in lower quality earnings and something investors would be willing to pay less for.

There is a negative correlation between inflation and valuations, in this case the price-to-earnings ratio of the S&P 500. As inflation reduces, valuations increase and vice versa. It is notable that even though equity markets have derated since the beginning of 2021 (partly a function of strong earnings growth) more could be expected if inflation remains at current levels for longer. For now, equity markets are taking the view that we will see only a temporary spike in inflation.

Global equity markets have largely been unaffected by recent inflationary concerns as investors have been focusing on the strong underlying growth environment and continued support from policymakers. The same holds true for developed market government bond yields, which have remained almost unchanged during the month. Faced with strong growth and sharply higher inflationary expectations, it seems counterintuitive that yields have suddenly stopped climbing, but much of this can be attributed to the ongoing cautiousness of the US Fed, which remains consistent in its view that interest rates will not begin rising until 2023.

It is critical to monitor the situation closely, as the prospect of tighter monetary policy, either through higher interest rates or less quantitative easing (tapering), earlier than expected, is something that is likely to cause volatility in most asset classes as tightening monetary policy too early has the potential to strangle economic recovery.

• Drotschie is chief of investments at Melville Douglas, Standard Bank’s boutique asset management firm.