At the start of the year, financial markets were rocked by fears of rising inflation and higher interest rates. Is fear of inflation justified and what impact will this have on your investments?
Strong economic figures and higher-than-expected wage growth in the US have pushed US rates higher in recent months while putting pressure on the financial markets. Inflation and interest rates, both inter-linked, have a major impact on various parts of the economy, including consumption and investment. Inflation increases the cost of goods and consequently affects consumers’ purchasing power, while rising rates push borrowing costs higher and can slow down investment.
Inflation can, therefore, have an important impact, … but what kind of impact, exactly? Inflation – reflecting an increase in global price levels – comes in different sizes and shapes. The most common indicators used to monitor price changes are the Producer Price Index and the Consumer Price Index. The focus here will be on the CPI, a measure that examines the weighted average of prices of a basket of goods and services and which is used to identify inflation. The Goods & Services basket includes foodstuffs, consumer goods, and renting and energy costs.
In the US, the goods basket has, for some time now, been dearer, with the latest figures pointing to a 2.5% increase in the last 12 months and the recovering commodity prices, especially the oil price, having certainly contributed to this increase. Excluding food and energy (two items prone to swingeing fluctuation and thus capable of distorting the inflation trend), inflation came out at 2.1%.
In the Eurozone, inflation remains low – indeed, under the ECB target of 2%. The Bank expects inflation to have sunk even lower by the end of 2020.
Inflation is a threat to investors’ savings and investments. Most investors, keen to at least preserve their long-term purchasing power, seek yields in excess of inflation levels. An investment delivering an inflation return of 3% will, for an inflation level of 2%, give a real return of only 1%. Those investing purely in bonds and who fail to sufficiently diversify their portfolio could consequently post negative real returns against a background of higher inflation. It is equally important to speak of a bond’s real rate rather than its nominal rate.
Inflation can, however, also have a positive effect on other asset classes such as equities and commodities. Commodity prices, as a rule, rise when inflation goes up. In the case of equities, the impact varies with the inflation increase and the period in question. Indeed, in the short term, there can be a negative correlation between equities and inflation. An unexpected increase in inflation can also, in its wake, bring uncertainty about the economic context, as was the case at the start of the year. Generally speaking, however, equities will benefit from inflation in the longer term. Indeed, companies can increase their product price when costs rise as a result of rising inflation. Higher prices can, after a period of adjustment, generate higher profit growth.
Various studies have shown that equities perform well at the start of an inflation cycle. Indeed, healthy inflation is a by-product of an improving economic context, so an inflation level of between 1.5% and 2.5% is generally positive for equity valuations.
Provided inflation remains manageable (i.e., isn’t negative or excessively high), equity investors need not fear an increase. Bond investors, however, have various tools at their disposal with which to protect their portfolio against an inflation rise:
Inflation-linked bonds are government bonds whose interest compensation and nominal value increase in line with inflation. This keeps investors’ spending power stable. Inflation-linked bonds, especially in the US, appear attractive and are supported by a strong inflation cycle, despite recent less persuasive figures. In the Eurozone, too, however, opportunities are thick on the ground, as inflation expectations are turning positive and valuations are attractive.
Bonds with a floating rate are also known as floating-rate notes; their coupon varies in accordance with the short-term interest rate. The coupon is then calculated on the basis of a reference rate, usually the 3M Euribor or the Libor (US), increased by a margin. With every rate increase, the value of the floating-rate bonds should remain stable and the coupon should increase. It’s worth giving a thought to diversification in the current environment.
You can also elect to diversify to bonds with a higher current return, although the risk here is clearly greater. We don’t much care for less well-performing high-yield bonds, as the interest-rate difference (spread between Euro high-yield and sovereign bonds) is lower than at any other time in the past ten years. We prefer emerging market bonds, currently benefiting from an accelerating economy, limited risk in China and improving fundamentals, such as government debt and the current-account deficit. In addition, these deliver a current return of between 5% and 6%. Within the asset class, we have a slight preference for emerging market bonds in the currency of the issuing country.