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Clearly, the inflation environment has changed. But the burning question is the stickiness of all of this. To be sure, this is not a return to the galloping inflation of the 1970s (which peaked at 14% in 1980). Back then, a series of inflationary shocks also plagued the economy – escalating costs of the Vietnam war, a doubling of the oil price in 1970 alone, and ultimately, the breakdown of the Bretton Woods system in 1971 (where the U.S. unilaterally terminated convertibility of the U.S. dollar to gold). Today, much of recent inflation is pandemic-driven. The world has just witnessed the largest supply collapse ever seen, caused by Covid lockdowns. Base effects and bottlenecks are now contributing to a surge in prices. However, these dynamics will moderate at some point, easing price pressures.
But the world has also just witnessed the largest demand surge since World War II, caused by reopening and policy largesse. This boom in global aggregate demand will continue. In fact, the kindling needed to light a blaze in demand can be seen almost everywhere.
This can be viewed through a consumer, corporate, and government lens. Household balance sheets in the major economies are in very decent shape, capital spending is booming, and governments have abandoned austerity. There is also a behavioral component: inflation expectations. The U.S. five-year breakeven inflation rate (a market-derived proxy for inflation expectations) has gone from an all-out collapse in March 2020 to breaking out of its historical range and hitting the highest level in nearly 13 years.
The glaring risk here is that forecasts become self-fulfilling prophecies. If inflation is expected to be higher in the future, people will be willing to pay more at current prices. As inflation rises above target, expectations become un-anchored. All of this suggests inflation will be far more stubborn than central banker forecasts.
Inflation is the key macro battleground among global asset allocators. Yet human beings have a habit of framing outlooks in a binary way: Will there be inflation or will there not? Or, investors focus on point forecasts: Just how high will inflation be?
Those are the wrong questions. Markets react to changes at the margin. And, importantly, they react to the interplay between expectations and the actual incoming data. That means the best approach for investors is to plan for asymmetry in positioning.
The reality is that many of today’s asset prices still reflect the disinflationary trends of the last 40 years. Western government bonds, in particular, are still pricing in a deflationary ice age. Looking out over the next three to five years, our investment team anticipates inflation to average modestly higher than the last two decades. Demand is still booming and is unlikely to ease any time soon.
Yet even with this moderate shift, investment leadership will radically change. Losing investments will be those that have been bid up on the “lower forever” inflation thesis. This includes the long-duration growth stocks that have become today’s darlings. Winners include bank stocks (which have become well-capitalized and are natural beneficiaries of a steepening yield curve) and industrials (and other sectors that can pass through rising costs). Other cyclical industries will come back in vogue. Emerging market bonds will catch a steady bid as there are few yield plays that offer positive real rates.
Higher inflation and higher rates hold the key to these secular shifts. Markets are nowhere close to pricing any of this in.
Tyler Mordy, CFA, is CEO and CIO of Forstrong Global Asset Management Inc., engaged in top-down strategy, investment policy, and securities selection. The Forstrong Global Investment team contributed to this article. This article first appeared in Forstrong’s “2022 Super Trends: World in Transition” publication available on Forstrong’s Global Thinking blog. Used with permission. You can reach Tyler by phone at Forstrong Global, toll-free 1-888-419-6715, or by email at tmordy@forstrong.com. Follow Tyler on Twitter at @TylerMordy and @ForstrongGlobal.
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The foregoing is for general information purposes only and is the opinion of the writer. The author and clients of Forstrong Global Asset Management may have positions in securities mentioned. Performance statistics are calculated from documented actual investment strategies as set by Forstrong’s Investment Committee and applied to its portfolios mandates, and are intended to provide an approximation of composite results for separately managed accounts. Actual performance of individual separate accounts may vary with average gross “composite” performance statistics presented here due to client-specific portfolio differences with respect to size, inflow/outflow history, and inception dates, as well as intra-day market volatilities versus daily closing prices. Performance numbers are net of total ETF expense ratios and custody fees, but before withholding taxes, transaction costs and other investment management and advisor fees. Commissions and management fees may be associated with exchange-traded funds. Please read the prospectus before investing. Securities mentioned carry risk of loss, and no guarantee of performance is made or implied. This information is not intended to provide specific personalized advice including, without limitation, investment, financial, legal, accounting or tax advice.
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