Beware inflation: it lurks before it spikes

October 08, 2018 08:48
Gold can be a hedge against both inflation and policy errors by central banks. Photo: Reuters

There was a time when investors feared inflation, but it hasn’t been much of a factor for almost four decades – neither in the global economy nor in many investors’ strategies. This has led to a degree of happy complacency for consumers, who don’t like inflation because it means higher prices, and for investors, who haven’t felt the pressure to strive for higher real returns.

At the same time, central banks generally seek to maintain a certain level of inflation to keep their economies growing; recently, 2 percent per year has been their target rate. Yet in the post-financial-crisis era, central bankers have essentially printed money through policies of low rates and quantitative easing, and inflation has barely budged.

Working against inflation are certain disinflationary structural forces – such as ageing demographics and a shrinking global workforce – that show no signs of abating. Increased competition and the rise of the digital economy are also making it more difficult for companies to raise prices. These are worrisome developments that raise the risk of a policy error by central banks as they attempt to meet their inflation mandates.

Why inflation could move higher

Even though inflation may be temporarily gone, it should not be forgotten. We believe there is a range of reasons to expect that inflation could move higher unexpectedly:

1. The price of oil appears likely to continue hovering near US$75 per barrel, which could be inflationary. An oil shock from the Middle East could drive prices up even more.

2. Diverging monetary policies among major central banks is causing currency-market volatility. For trade-reliant countries, weaker currencies mean import inflation, which can undermine real consumer spending and investment.

3. As China reforms its state-owned enterprises and the country begins exporting for profit rather than employment, higher traded-goods prices could help exporters but hurt consumers.

4. Trade wars will hopefully be short-lived, but friction between the United States and China or others is likely to deliver a small increase to global inflation.

Central banks are taking different approaches to inflation

The global economy made its way out of the 2007-2008 financial crisis by using record-low interest rates to pile on debt. A great deleveraging is overdue, yet much of the world’s debt may not be reduced by the usual measures – repayment or default – but instead repaid with “default by inflation”.

In this sense, central banks are likely to celebrate inflation rather than try to quash it like they did decades ago. But since each economy faces a different set of threats and opportunities, investors should expect a variety of approaches from central banks managing diverging economies.

What investors can do to help fight inflation

Given the relative lack of inflation in recent years, too many investors may be neglecting to protect their portfolios. This is a mistake, given that even relatively low levels of inflation can significantly erode purchasing power over time.

To combat inflation, consider real assets like commodities and real estate, which have traditionally held their real value better than financial assets like bonds and cash:

1. While property has always been a good hedge, it is expensive in many regions, reducing its usefulness unless held for many years.

2. Infrastructure assets often provide the potential for attractive long-term returns and help institutional investors with liability matching – albeit with now lower levels of yield.

3. Gold can be a hedge against both inflation and policy errors by central banks.

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As Global Strategist at Allianz Global Investors, Neil Dwane is responsible for presenting strategic house views and overseeing the Economics and Strategy Research teams.