Inflation is back on the cards – should investors be worried?

Higher inflation is bad news for cash and bonds, a mixed bag for gold but positive for the dollar

Steven Castelluccia / The National

This was supposed to be the year the global economy bounced back from the pandemic and the stock market threw a great big party to celebrate.

That could still happen, but there is a spectre lurking at the feast.

Inflation.

Investors fear that all the monetary and fiscal stimulus pumped out to spare us the ravages of the pandemic could whip up inflation and force central bankers to increase interest rates to bring prices back under control.

Higher borrowing costs would be bad news for governments, businesses and consumers, wrecking the recovery.

Inflation wreaked havoc in the 1970s as energy prices soared and growth stagnated, but the beast has been tamed for decades. So how scared should we be?

It may seem daft worrying about inflation today, given that US consumer prices rose just 0.4 per cent in the year to February.

That is a far cry from the 1970s, when inflation regularly topped 20 per cent and salaries struggled to keep up.

US President Joe Biden’s $1.9 trillion stimulus bill could quickly change that, though. The package includes a one-off payment of $1,400 to most Americans, and comes on top of a $900 billion relief package in December.

This will lift total US fiscal stimulus since the pandemic to more than 15 per cent of gross domestic product, and it isn’t the only country going on a splurge.

Eurozone stimulus will boost GDP by 7 per cent, while Japan’s measures total 4 per cent of its economy, according to Organisation for Economic Co-operation and Development figures.

In addition, Thomas Costerg, senior US economist at Pictet Wealth Management, warns US households are set to spend at least some of the $1.5tn of savings accumulated during last year’s lockdowns, which could fuel “economic overheating”.

The US Federal Reserve now predicts the US economy will grow by 6.5 per cent this year, up from 4.2 per cent just three months ago.

It also revised down its unemployment forecast, from 5 per cent to 4.5 per cent by the end of the year.

That’s good news. Up to a point.

Many governments will welcome higher inflation because it will erode the real value of the colossal debts built up since the financial crisis.

There’s a catch, though. If inflation rises too high, businesses struggle to set prices and consumers find it harder to plan their spending.

Worse, it may force central bankers to increase interest rates faster and higher than expected. Everybody’s loans and mortgages will become more expensive to service, making indebted consumers and businesses feel poorer.

It will also drive up the cost of servicing government debt. The UK Treasury estimates that for every 1 per cent interest rate increase, its interest bill will rise by a thumping £20bn ($27.74bn) a year.

Governments and consumers have spent the past dozen years loading up on cheap debt. They could buckle if it gets more expensive.

Unfortunately, that is exactly what is happening. In May last year, the yields on 10-year US Government bonds, or Treasuries, hovered around 0.51 per cent. At the time of writing, they stand at 1.72 per cent.

That is still low by historical standards, but means they have more than tripled in the past year.

Bond yields are rising because investors anticipate rising inflation and are demanding a higher return.

Last week’s Fed monetary policy decision was hotly anticipated to see whether chair Jerome Powell would act to head off the inflationary threat. Instead, he remained dovish and Fed policymakers suggested that interest rates will not start rising until 2023, sending the S&P 500 to a record high.

Olivier Konzeoue, FX sales trader at Saxo Markets, says: “The Fed is happy to see inflation run hot for some time in order to return to full employment by 2023.”

Chris Beauchamp, chief market analyst at IG, says the decision drove up bond yields and they look set to push even higher.

“Markets continue to assume that things will go much better than expected and the Fed will have to move sooner than the current forecasts indicate.”

“Inflationistas have been crying about the risks of higher prices for years, and they are not likely to stop now,” he adds.

So, how should investors respond?

If inflation takes off but interest rates stay low, cash will be an even worse place to leave your money. Today’s near-zero savings rates look bad enough with inflation at 0.4 per cent, but would look woeful if it flew past 4 or 5 per cent.

Investors holding government and corporate bond funds will also take a hit. Bonds pay a fixed rate of interest, which looks less attractive when inflation and interest rates are climbing.

As bond yields rise, prices fall, hitting the capital value of existing holdings.

Darius McDermott, managing director of Chelsea Financial Services, is wary of buying government bonds today. “Instead, I would favour strategic bond funds that can shift in and out of government and corporate bonds as conditions change.”

He also favours higher yield corporate bonds. “The companies issuing these bonds have a slightly higher risk profile, but these are the types of businesses that should do well if we get an economic recovery.”

As a traditional store of value, gold is often seen as an attractive asset to hold when inflation takes off. The precious metal has lost its shine after hitting an all-time high of $2,068 last August, falling 16 per cent to around $1,735.

Some could see this as a buying opportunity, but there is also a downside. Gold doesn’t pay any interest, which makes it less attractive if savings rates and bond yields rise.

Fawad Razaqzada, market analyst at ThinkMarkets, says: “Investors would question holding onto something which costs money to store when they can invest in government bonds that pay some interest in return.”

If the Fed does increase interest rates, the US dollar recovery will accelerate. The US Dollar Index has been strengthening in anticipation.

Higher inflation is bad news for cash and bonds, a mixed bag for gold and positive for the dollar, but what about shares?

Nick Wood, head of fund research at Quilter Cheviot, says growth stocks such as US technology companies have done well over the past year, but higher inflation could “upset the apple cart”.

Investors should make sure they are not over exposed to recent “growth darlings” such as Amazon and Tesla, or the funds that invest in them. Higher inflation is bad news for growth stocks like these, as it erodes the value of future earnings.

Many investors will be overexposed to growth stocks following recent successes, and may want to rebalance their portfolio by adding some value stocks. These are companies, often big dividend-paying blue chips, that look cheap relative to their earnings and long-term growth potential.

Value stocks have underperformed lately, as investors chase growth, but tend to perform better when inflation is higher. They offer income and growth today, rather than the prospect of growth tomorrow.

The banking sector could benefit from higher inflation, as this will allow them to increase their net interest margins, the difference between what they earn from taking in deposits and lending money out.

Commodity stocks may also benefit, particularly mining companies, Mr Wood says. Globally diversified miner Anglo American is up 122 per cent in the past year, while Chile-based copper producer Antofagasta is up 137 per cent.

The copper price is at a 10-year high and Mr Wood says other metals and minerals are performing equally well.

“Commodities are seen as good inflation hedges, plus they have a part to play in the energy transition, as they are needed for the production of green infrastructure, batteries and electric motors.”

If inflation really lets rip, that will be bad news for stock markets, too, particularly if we see the return of a 1970s-style “stagflation”. This happens where inflation climbs but the economy stagnates, and is generally seen as the worst of both worlds.

We are a long way from that, but it can’t be ruled out.

As ever, second-guessing market movements is risky, so the safest response is to make sure your portfolio is diversified and balanced between shares, cash, gold, property, bonds and increasingly, commodities.