By David Thomson
Savers and investors should always factor in inflation to their calculations as it erodes the purchasing power of their returns.
Today with such low cash returns even inflation at around 1% means there is precious little, if any, real return on cash deposits.
But should they be worried about inflation getting well above current levels? It is a question many investors are asking themselves as inflation is now so low as a consequence of the pandemic it appears that it can only rise from here.
In the UK, the annual consumer prices index including owner occupiers' housing costs (CPIH) rate of inflation rose in January to 0.9% from 0.8% in December 2020, before dipping to 0.7% in February.
The Bank of England likes to keep annual consumer prices index inflation (CPI) around 2% so there is some way to go before that target is achieved.
Many economists are expecting inflation to exceed 2% in the short term, partly as it rises from a low base and also because the Covid pandemic will have taken out capacity in some sectors of the economy, resulting in shortages of supply and attendant price increases.
Investors are concerned that all of the added stimulus in the form of quantitative easing to support government spending around the globe such as Joe Biden’s recent $1.9 trillion economic support package, coupled with ultra-low interest rates, could fuel a spending boom with a corresponding knock-on effect on inflation.
With interest rates so low the fear is that they will have to rise to counteract a more prolonged period of inflation. With rates so low, even small, anticipated movements are having a significant impact on the fixed interest markets.
As investment is also a relative game this has had a knock-on effect on shares, particularly those longer-term growth companies that are more dependent on longer-term interest rates.
These have also been the companies that were benefiting from the ultra-low interest rate environment. In recent weeks investors have been looking at a disconcerting environment where good economic news has been detrimental to stock market returns.
However, Janet Yellen, the Treasury Secretary, and Jerome Powell, chairman of the US Federal Reserve, have dismissed fears that Biden’s $1.9 trillion pandemic-relief bill will lead to inflation, in doing so casting doubt on the reflation fear that has spooked markets since the turn of the year.
Ms Yellen stated that prior to the current crisis the unemployment rate in the US was about 3.5% and that there was “no sign of inflation increasing”. She added that before the pandemic inflation was already “too low rather than too high” and even if there were signs of inflation getting out of control, they had the tools “to deal with that”.
Although prices are likely to rise in some areas, few see this feeding through into the wage inflation that central bankers worry most about; as unemployment levels will take some time to get back to their pre-Covid low.
Ms Yellen also spoke about the shape of any recovery, believing that a K-shaped recovery trajectory – the divide between the haves and have-nots – is what she is seeing. “We have a K-shaped recovery going on, in which high-income people are doing much better than those at the bottom of the economic ladder”. This was a problem before the coronavirus; however, the pandemic has exacerbated it.
The major implication of a K-shaped recovery would be that both monetary policy accommodation and fiscal policy assistance will continue for longer due to central banks and governments having to support the “have-nots” for longer whilst knowing such schemes are benefiting the “haves”.
The question for investors now is do they hold their nerve as inflation rises or switch to those areas of the market that typically benefit from inflation such as commodities and property.
David Thomson is chief investment officer at VWM Wealth
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