Inflation: More Friend than Foe?

Some market participants are concerned that the reflationary recovery that started last year will morph into something more sinister with overshooting and sustainably higher inflation. The latest U.S. CPI inflation print is an example of the current inflationary pressure that has been building and we expect subsequent prints to show similar pressures. Excessive and persistent inflation could put the equity rally at risk as central banks would be forced to react taking the punch bowl away from the still partying market.

Let us investigate the inflationary outlook by comparing the cyclical versus structural inflationary backdrop going forward. Given the outsized effect on global economies and markets, the focus will be on U.S. inflation.

Cyclical Outlook

We believe that the economy operates in an environment in which growth influences future core inflation. In the U.S. for example, real GDP growth has been a reliable indicator for core inflation for the last 25 years. We are forecasting U.S. growth to continue to rebound far above its trend-level and expect inflation to follow higher, at least in the short-term until growth subsides to more normal levels.

Good vs. Bad Inflation

We generally think of inflation resulting from stronger growth as “good” inflation, whereas inflation resulting from supply disruptions as “bad” inflation. One of the most interesting aspects of the COVID recovery has been the strong demand for goods – things like home furnishings, electronics, autos and recreational goods while services consumption has been weak as COVID has limited the mobility of consumers.

Supply Disruptions

The strong demand and more challenged supply have led to pockets of “bad” inflation. Higher commodity prices, longer delivery times, and industry-specific labor shortages have all emerged. We do however view this as more transitory as service sector demand rebounds and goods demand slows, supply chains recover, and workers are pulled back into the labour market, but expect the transition period to be volatile and slow.

Central Banks

We believe the U.S. Federal Reserve Board (Fed) and other central banks, like the Bank of Canada (BoC), will remain accommodative and look past shorter-term inflation pressures.

In the Fed’s case, they have adjusted their mandate allowing an inflation overshoot to make up for a persistent undershoot in the past number of years. The updated approach points to higher inflation risk if ever the Fed underreacts to inflation pressure. Still, the Fed and the BoC’s view that higher inflation will be more transitory, not structural, should keep its interest rate policy dovish for some time.

Secular Outlook

Despite higher cyclical inflation, we are not yet convinced that inflation will trend higher on a secular or more sustained basis. This is key as central banks like the Fed and the BoC will look through cyclical spikes in inflation but would be forced to react should inflation start to look like it is increasing more secularly.

Here are some compelling arguments for and against the case for secular inflation:

In general, it is very hard to know how the inflationary backdrop will unfold over the next three to five years, but we think it is advantageous to wait for more evidence before positioning portfolios for higher secular inflation.

Conclusions and Portfolio Positioning

We believe inflation will rise over the next year, following extremely strong growth in the economy. Mostly, we consider this “good” inflation, although there is growing evidence that supply constraints are creating some “bad” inflation that could be more persistent. We ultimately believe these inflation pressures will be transitory and are not yet convinced that inflation will stay makeable above trend on a secular basis.

We remain overweight cyclical assets like equities and credit and underweight fixed income securities. Having lower duration to position for higher cyclical inflation and interest rates is recommended in this inflation environment. However, this year may present a good buying opportunity for duration if the market reacts too much to a cyclical inflation overshoot and rates spike higher against a backdrop or more benign long-term inflation.
Comments, opinions and analyses are for informational purposes only and should not be considered individual investment advice or recommendations to invest in any security or to adopt any investment strategy. Because market and economic conditions are subject to rapid change, comments, opinions and analyses are rendered as of the date of the posting and may change without notice. The material is not intended as a complete analysis of every material fact regarding any country, region, market, industry, investment or strategy.