The outlook for inflation and implications for investment strategy

Since the beginning of the credit crisis in the summer of 2007, and with greater determinedness in the wake of Lehman Brothers' collapse in September 2008, governments and central banks have taken extraordinary measures to shore up the world's financial system and to avert economic depression. These measures, which have included the imposition of near-zero interest rates, the large-scale expansion of the money supply via 'quantitative easing' (essentially the creation of money) and powerful fiscal stimulus, have contributed to concern about a likely surge in inflation. Some commentators warn that this may, as in the 1970s, become embedded in the world's economic and financial systems.

Investors have good reason to be wary of inflation, with rising costs implying a diminution in their purchasing power. Rising rates of inflation affect different investors in different ways, depending on the nature of their commitments; defined-benefit pension schemes, for example, may be particularly vulnerable to the implications of rising wages and increases in the value of the liabilities those schemes must meet. 'Headline' measures of inflation, which focus upon the change in the price level of a basket of consumer goods, may fail to capture adequately these actual pressures.

Other than the modest acceleration seen recently in consumer price inflation in some regions (driven principally by very low commodity prices in early 2009 dropping out of the data), indicators of inflation are generally quiescent.

While the impact of highly accommodative monetary and fiscal policy is evident in the growth of the money supply in the world's major economies, the influence of that policy on 'real' economic activity has been muted. This is largely because commercial banks have preferred to take steps to boost their liquidity and repair their ailing balance sheets rather than to convert policymakers' largesse into lending to businesses and consumers.

Figure 1 shows the U.S. 'monetary base' (which is defined as notes and coins in circulation plus bank reserves). The increase in the monetary base over the last two years has been vast, even in comparison with the previously 'unprecedented' increases at the turn of the millennium and in the aftermath of the terrorist attacks of September 2001.

It is this creation of money that is contributing to inflation concerns, albeit that enlargement of the monetary base has given rise to the appearance of overvaluation ('bubbles') in asset classes such as bonds and emerging-market equities rather than to sustained expansion in the manufacturing and services sectors. However, stripping out the 'excess reserves' deposited with the Federal Reserve, which reflect the desire of banks not to be caught out by another liquidity crisis, the growth in the monetary base is actually modest. In short, because the desire of banks to hoard cash has increased (and arguably too because borrowers are intent on repaying their debts rather than increasing them), credit creation by the private sector is constrained. This is in no small part attributable to governments' requirements for commercial banks to be recapitalized and to hold more capital (and to hold it in more liquid form). Credit creation and lending policies consequently are somewhat enfeebled.

The marked decline in demand in the autumn of 2008 and spring of 2009 created significant spare economic capacity, both in the developed and developing worlds. Thus, the possibility of a shortage of 'normal' industrial goods and commercial services seems distant and an unlikely source for the revival of inflation. In isolated areas, there have been upward pressures on prices, for example in certain foodstuffs such as tea and cocoa. In the absence of an unexpectedly vigorous increase in economic activity, such strains appear, however, to be containable.

Similarly, there is, in the private sector at least, little sign of wage inflation. Indeed, many corporations have stated their resolve strictly to limit any pay increases in 2010 and wage restraint is evident in official earnings data. The public sector has been less affected than the private sector but, given the scale of fiscal deficits in many developed economies, there is almost certain to be an attempt to exercise restraint over rewards for the public sector in such economies. As events in the 'olive belt' of Europe are demonstrating, austerity is increasingly becoming a feature of government policymaking.

Debt-raising activity by numerous governments around the world, and the gradual cessation/withdrawal of stimuli, should limit price pressures. However, the obsession of central bankers with consumer-price-related inflation targets, together with a desire to support employment, entails a tendency towards excessive policy stimulus. This tendency may be particularly extreme in the current environment, given that the large 'overhang' of unemployment and spare industrial capacity appears to afford policymakers ample scope to maintain loose policy.

Inflation may enter through the 'back door', via changes in exchange rates both in emerging markets (where currency controls have preserved export potential but begun to raise the cost of imports) and in developed markets where domestic demand outstrips domestic supply. The UK is more vulnerable than many countries, given its lack of growth, the magnitude of its public debt, the openness of its trading system and the service-oriented nature of its output.

Given the uncertainty about the outlook for inflation, investment strategies should incorporate ample exposure to 'real' assets. Treasury Inflation-Protected Securities ('TIPS') might be favored over conventional fixed-interest securities, although they appear to offer only average value at present; the real (inflationadjusted) yield on the 10-year TIPS stands at 1.5% 1 and, with inflation of 2.3% per annum for 10 years being implied by the difference between Treasuries and TIPS yields, 2 some inflation threat appears already to be priced in.

Property (despite the 'penalty' of illiquidity) and commodity-related assets (oil, gold and base metals) have attractions; and equities, particularly those with global reach and with above-average and growing yields (which serve to smooth the volatility inherent in stock-market investment) should be prized. Defensively positioned, cash-generative companies with sustainable dividends should perform well against such a challenging economic background, particularly given their recent underperformance versus more economically sensitive counterparts.

A balance of equities, property, commodity-related assets and, perhaps, inflation-protected government bonds should provide an each-way 'bet'; if inflation does not take hold, such asset classes should engender healthy, long-term returns. Should inflation return, all asset classes would be tested, but those which offer long-term, real returns are likely to be favored.

1. Source: Bloomberg, April 14, 2010.
2. Source: Bloomberg, April 14, 2010.