BNP AM

The official blog of BNP Paribas Asset Management

Jenny Yiu
2 AUTHORS · Economics
09/03/2022 · 5 min read

Inflation is back – and here to stay

Inflation has rebounded from its pandemic-induced recession lows with a vengeance. In the US, the headline CPI rate accelerated to a 40-year high, while the eurozone headline HICP rate surged to the highest level in its entire 20-year lifespan. What does this mean for investors?



Russia’s invasion of Ukraine is a new exogenous supply shock. It will likely further exacerbate inflationary pressures and reduce real disposable incomes with negative consequences for economic growth.

At the start of 2021, many still thought inflation would be ‘transitory’. Distortions coming from the pandemic, be it supply bottlenecks or reopening effects, were the major drivers. These sources of inflation were expected to resolve themselves over time.  This has not happened. 

Is the world entering a new inflation regime?

The pandemic will likely accelerate fundamental shifts in consumer demand, labour and financial markets, as well as in global economics. A return to a disinflationary cycle is not probable in the foreseeable future. 

Parallels can be drawn between present day and the Great Inflation regime when inflation peaked at above 14% in 1980. Deficit-funded spending was one of the culprits. Today, massive pandemic-era fiscal packages have been followed by plans for infrastructure and social spending at a time when developed economies are already at or close to full employment. 

We face supply-side shocks similar to those seen in the 1970s: supply chain disruptions, higher energy prices and labour market shortages. Businesses are passing on the higher costs to their customers, and there is evidence of second-order effects from higher energy prices.

This constellation is leaving policymakers with a dilemma – tighter monetary policy will not help address the root cause of supply shortages, but could make things worse by undermining the economic recovery. At the same time, leaving monetary policy too loose would risk inflation expectations becoming unanchored.

Near-term inflation outlook

We are not calling for a return to 1970s-style inflation. We believe central bankers are well aware of the lessons from that time. As for the inflation outlook, we believe that in the near term, sustained inflation moderately above central bank targets is likely in major developed economies. 

In the US, inflation pressures are due to supply bottlenecks, cyclical factors and structural forces. Once the bottlenecks clear and consumption switches from goods to services, a stronger job market, rising shelter costs and tight commodity markets will keep inflation from falling back to the US Federal Reserve’s target.

In the eurozone, the inflation spike is mainly due to rising energy prices. However, higher inflation, rising minimum wages and a robust recovery may trigger faster wage growth this year.

Longer-term catalysts for inflation revival

Technological advances and digitalisation will likely help contain inflation, but other secular forces are becoming less disinflationary, or even inflationary:    

  • Debt - There is no appetite for austerity. If central banks find themselves with no choice but to keep policy easier than they should to accommodate fiscal deficits and deliver full employment, investors could start to worry about fiscal dominance. [1] High debt loads could incentivise policymakers to tolerate more inflation.
  • Demographics - As more of the global population switches from being net producers to net consumers, competition for productive workers will rise, and wages should increase. Similarly, as more savers start to consume more services, demographics could become inflationary.
  • Globalisation / Protectionism - Governments are recognising that sectors such as medical goods and semiconductors have a national security importance that requires domestic self-sufficiency and protection. This and efforts to improve the responsiveness and resilience of supply chains will likely encourage reshoring of manufacturing, protecting domestic capacity from international competition. 
  • Inequality & Politics – The fight against inequality could have an inflationary impact. Income and wealth inequality is disinflationary since the rich have a higher propensity to save while the poor are more inclined to spend. A political consensus on the need to combat the widening income gap, and for redistributive fiscal policies and higher wages, could prove inflationary.
  • Green transition - To cap the rise in global average temperature to 1.5C, a notable rise of carbon prices will be needed to accelerate the transition and dis-incentivise new investments in fossil fuels. Furthermore, a rush to build renewable energy production could be costly, while fall-backs on traditional buffers to handle any energy shortages could lead to higher and unstable energy prices. 

Using inflation-linked bonds as hedges

As the case for an inflation revival has strengthened, and inflation uncertainty is high, it has become increasingly important for investors to manage inflation risks. Since equities and bonds typically do less well in periods of high and rising inflation, investors should consider allocating to inflation-sensitive asset classes to improve a portfolio’s resilience against inflation risks.

For investors looking for a fixed-income solution to hedge against inflation, inflation-linked bonds can be an important building block.

The coupon and principal of these bonds are uprated in line with a referencing inflation index. Returns from these bonds consist of a realised inflation and a real duration component.

Inflation-linked bonds held to maturity compensate for realised inflation as it accretes over the life of the bond. In a portfolio, swapping out nominal bonds for inflation-linked bonds can provide robust inflation protection over the long term. Also, the real duration component can offer diversification benefits against equities in an economic downturn. 

Reference

[1] Under fiscal dominance, the size of government debt is such that the primary role of monetary policy is to avoid bankruptcy rather than to serve as a tool in managing growth, inflation and employment. 

Disclaimer

Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. The views expressed in this podcast do not in any way constitute investment advice.

The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns.

Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions)

Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.



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