In the most recent BofA Securities’ monthly survey of global fund managers, the biggest fear was a ‘taper tantrum’ in the bond markets if the Federal Reserve tightened monetary policy in response to rising inflation. Inflationary pressures appear to be mounting and money has poured into inflation-linked bonds.
Is this concern justified?
The survey showed 93% of fund managers expect higher inflation over the next 12 months – an all-time high. At the same time, there are clear inflationary signals emerging in the US. In the latest earnings season, corporate America – from Walmart to Mattel – started complaining of rising input prices, laying the foundations for price rises of their own. Higher commodity prices, stimulus cheques and pent-up spending all lay the foundations for higher inflation.
Certainly, a short-term bounce in inflation appears to be an inevitable consequence of recovery, government spending and the bottlenecks created by the pandemic. The Federal Reserve has made it clear that it will overlook short-term rises in inflation when considering setting interest rates through its ‘average inflation targeting’ policy. The question is whether it endures into 2022 and 2023, forcing a snap rise in rates of the type that has typically tipped the US economy into recession.
Built up debt
There are some elements that are different this time and could prompt higher inflation. Ben Lofthouse, head of global equity income at Janus Henderson Investors, says: “There have been numerous calls that inflation might be round the corner and generally it hasn’t come […] the biggest change is that, today, we don’t have as much call for austerity.
“Historically, there has been a call for austerity and the tightening of government budgets and spending […] pre-Trump, Obama was kept under tight control by Republicans because they didn’t want any more debt. Ironically, we had lots of debt under Trump and lots of debt over the past year. That’s the main area of debate relevant for embedded inflation taking hold, whether we’re moving to lax fiscal and monetary policy.”
Lofthouse added: “In a year’s time we’ll have a better idea about how much of this fiscal support continues.”
The US consumer will be important. Retail spending blasted out of the blocks in March, showing a rise of 9.8% for the month. People have stimulus cheques in their pockets and a sizeable minority have been able to save during the pandemic. This pent-up spending is seen as a key source of inflation risk.
Not rushing to the mall just yet
However, in its most recent Cyclical Outlook paper, Pimco said that it isn’t expecting consumers to spend all their accumulated savings: “Historically after recessions, the savings rate tends to remain somewhat elevated relative to its pre-recession level as consumers build back savings and ensure they can maintain consumption in the event of another downturn. Second, much of this excess saving is concentrated on the balance sheets of wealthy households, which are more likely to continue saving and investing the additional wealth.”
The bond markets are generally a more reliable barometer of inflation than equities. Undoubtedly there has been increased buying of inflated-linked bonds, though this has stabilised over the past month. Ed Smith, chief economist at Rathbones, adds: “For all the talk of ‘runaway’ inflation, long-term inflation expectations have barely moved for the last two months.”
Slow stimulus but quick tax hikes
Tax rises appear inevitable. Biden now has around $1.6trn in tax rises going through congress. While these may be watered down, it may help keep inflation in check and balance the stimulus packages. After all, while the stimulus package will be spent slowly, tax rises could come into effect more quickly. This could mean that the fiscal stimulus packages are not as inflationary as they would initially appear.
Against this backdrop, on balance, inflationary pressures look likely to subside once bottlenecks clear and the initial blast of pent-up spending works its way out of the system. There are risks – and it is easy to see why fund managers are nervous – but interest rate rises still look some way off.
Where are the pressure points?
This backdrop has generally been a good one for the stock market. Lofthouse says: “In general a move from having inflation to expecting some inflation is considered quite good for equities. At the moment, it is helping most with financials, which have seen a strong performance over the last six months or so after the worst of the crisis. Some sectors, such as materials and commodities have moved up considerably. Overall, there are still enough cheap areas with yield, where the risk of interest rate rises doesn’t matter too much.
“The pressure point may be in areas such as defensives – pharmaceuticals, staples and utilities, for example. They would struggle in a more inflationary environment and have underperformed significantly over the past 12 months for that reason. However, he adds that should the Federal Reserve raise short-term rates, these areas may – counterintuitively – perform well. “If you do get actual rate increases, you get the opposite of what you anticipate so some of the defensives start to perform when short-term rates start to rise. This is because people believe it will choke off growth.”
However, it’s not a scenario he’s forecasting yet. Ultimately, while markets (and fund managers) like to climb a wall of worry, runaway inflation and higher interest rates don’t look likely to take hold. That said, markets could be volatile while investors digest a short-term inflationary spike as economic recovery builds momentum.