Since February 2020, fund managers have consistently ranked COVID-19 as the greatest tail risk for investors, according to the monthly Bank of America fund manager survey. But, for the first time in over a year, the most recent survey (released in March) saw a different issue take the top spot: inflation.

The Bank of America fund manager survey asks global portfolio managers to report which issues affecting investments they are currently concerned about. In March, the survey concluded that inflation is currently considered to be the biggest tail risk, concerning 37% of managers surveyed. A net 93% of fund managers reported that they expect higher inflation in the next 12 months, up 7% from the prior month’s survey to an all-time high.

There is little doubt that inflation will rise in the coming months. US inflation is forecast to increase from 1.2% in 2020 to 2.5% in 2021, and an intra-year annual inflation rate of as much as 3.5% by May. Reasons for the increase include a rebound in prices from the weak levels recorded last year (during the worst of the early pandemic) coupled with increased spending from pent-up demand.  

Many investment commentators are now asking whether inflation will return with vigour over the next decade.

The past 50 years can probably be categorised into two distinct periods of inflationary experiences.

The 1970s saw oil prices rise 600% in 1973 and nearly 200% again in 1978-9, in the textbook example of cost-push inflation. US inflation grew out of control, rising from under 3% in 1972 to 12% in 1974 and peaking at 15% in 1980, due to an underwhelming policy response, with the Federal Reserve retaining interest rates at or below inflation.

A key lesson for central bankers from this episode was that you could control inflation if you are determined enough.

When a new Fed Chairman, Paul Volcker, was appointed in August 1979, he aimed to contain inflation through a combination of tight monetary policy (with interest rates higher than inflation) and incomes policies that de-indexed wages from inflation. His approach was successful, and inflation fell from nearly 15% to below 3% by 1983.

The key lesson for central bankers from this episode was that you could control inflation if you are determined enough. The subsequent 40-year period has seen interest rates and inflation fall to very low, even negative, levels as developed world central banks have targeted steady inflation levels of typically around 2%.

While highly influential, central bank policy is not the only reason for the reduction in inflation levels. We must consider it in the context of the other factors that have been at play.
 

• Total debt levels (including consumer, corporate and government debt) have increased markedly over time, which has discouraged private-sector consumption.
• There has been huge growth in the population of older people, who typically consume less and save more.
• Globalisation has replaced expensive home-grown supply chains with less expensive products from overseas markets.
• Digitisation has replaced the human labour force and reduced the bargaining power for labour, so wages have not kept pace with inflation.
• The internet has improved price discovery and helped to keep a lid on prices.

Undoubtedly, these deflationary forces will continue over the next decade. However, there are reasons to believe that inflation could be much higher in the medium term, as both monetary and fiscal policies are very loose and appear more likely to generate inflation than in the past.

One of the key economic relationships is between the money supply and inflation, i.e. a sharp increase in the money supply should lead to an increase in inflation. The central banks’ policies of quantitative easing (the creation of new money to purchase government bonds, driving down interest rates) should have increased inflation levels over the past decade but, on the face of it, the policy does not appear to have worked.

However, one criticism of the policy is that the new money was retained in the financial system, leading to financial asset price inflation (with both bonds and equities experiencing high levels of returns). Today, the newly created money is being spent by governments to support economies through the pandemic and to boost growth to escape the current weakness.

The potential advent of monetisation of debt is becoming more real.

In addition, it appears that the austerity policies of past governments will not be tolerated in the current political climate, especially with an agenda of tackling inequality. As a result, the potential advent of monetisation of debt (commonly known as Modern Monetary Theory;  the funding of government deficits through the direct purchase of government bonds by central banks) is becoming more real.

Connected to this, central banks appear more tolerant of rising inflation levels. The US Federal Reserve has explicitly adjusted its monetary policy to target average inflation over a longer period, allowing inflation to run hot for a period of time.

In conclusion, two clear camps have emerged on the outlook for future inflation. On the one hand, many believe that the deflationary forces that have been in place for some time will persist and see the current bout of inflation as transitory as price levels return to “normal” next year. Others believe that inflationary forces have been re-ignited and are here to stay.

Charities, which typically invest on a very long-term time basis, will be more aware than most of the harm inflation can have on their portfolios and the need to guard against it.

Conventional bonds and cash tend to perform poorly, as higher price levels erode the value of fixed returns. Inflation-linked bonds and long-term infrastructure assets can be used to provide some protection. Equities and properties may also be appropriate, as their revenues and rent tend to rise with inflation.

At Investec, we understand the goals of your investment portfolio and the risk inflation poses. Our investment managers work with our extremely experienced in-house research team to determine the right asset allocation to mitigate risk, safeguard your portfolio, and leave you to focus on helping your charity to help others.

Darren Ruane leads the fixed interest investment process, alongside colleagues in the bond team, and he contributes to a number of the decision-making investment committees including Global Investment Strategy Group, Asset Allocation and Investment Committee. He is the chairman of the recently formed Fixed Interest Investment Selection Committee, which provides model bond portfolios for various solutions. He also advises the company on its bank lending as part of the Cash & Credit Management Committee. He works with many of the largest institutional clients within the business including insurance companies, pension funds and charities. Investec clients in these areas benefit from our expertise in asset-liability matching solutions and the provision of low volatility portfolios.

To contact or read more about Darren Ruane, visit his bio here.