First, globalisation has driven international competition, helping create global prices. This means that each country’s prices are less sensitive to its domestic labour market and are instead influenced by the global economic situation. Second, financial markets have grown in importance and the trend is likely to continue as both the eurozone and China are promoting direct funding of companies.
Inflationary trends could now resurface independently of the actual economic situation
As a result, consumer prices are now moving in line with investor expectations on inflation. In other words, companies are raising prices because investors expect inflation to accelerate. Both macroeconomic developments have made us cautious over inflation trends as they now depend on subjective factors which are a far cry from the labour market analysis that used to prevail in the 20th century. Inflationary trends could now resurface at any moment, independently of the actual economic situation. At the same time, investors have never been as sensitive to oil price fluctuations so any rapid surge could have a much bigger impact on asset prices and therefore consumer prices, and that might send the global economy into a recessionary cycle.
Should investing styles adapt to these structural changes?
As inflation expectations in the last 35 years have essentially trended lower, recent history provides insufficient examples to establish a reliable comparison over a full cycle.
But two points stand out:
- High inflation has never been good for financial portfolios as it hits both bond and equity returns. Its supposed role as a protection for real assets is a myth. In the 1970s, real returns on US bond indices were -1.7% a year compared to -0.7% for equities, or only slightly better than Treasuries (-1%)1. Financial modelling confirms that inflationary periods appear to hit equities less than bonds over the first three years but the impact lasts longer for equities as rising interest rates end up protecting bond performance. Equity market analysis shows that PEs historically peak wheninflation is between 1% and 3%2.
- Any significant rise in inflation expectations would cause central banks to raise real rates. And the impact on global growth would be aggravated by current levels of indebtedness. All of which suggests that equities would no longer act as a safe haven asset as they did in the 1970s.
Inflation-indexed bonds and gold should manage to do well but their returns too would suffer from any increase in real rates, leaving a question mark over how they would perform across a full inflationary cycle. Physical property appears to offer reasonable protection but REITS3 struggle to perform as well. Commodities offer satisfactory protection against inflationary risk but are rather volatile and would not necessarily act as a sustainable refuge.
Recent developments show that inflation could all of a sudden get out of hand. This is not, however, our preferred core scenario. But were inflation to resurface, we should beware of investment platitudes as there are no obvious, sustainable solutions. Instead, investors should opt for active investment strategies to weather inflationary phases and focus on certain investment styles.
1 Source: Triumph of the Optimists / 101 years of global investment returns by Elroy Dimson, Paul Marsh and Mike Staunton
2 Source: Edmond de Rothschild Asset Management
3 Real Estate Investment Trusts are listed property vehicles.
Group Chief Economist
Head of Asset Allocation and Sovereign Debt
This analysis is an extract from the first House View published by Edmond de Rothschild.
This publication presents Edmond de Rothschild’s key convictions for macroeconomics, asset allocation strategy, and the principal asset classes.
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