Inflation: The good, the bad and the ugly

This is reassuring for those concerned about long-term economic stagnation, but inflation comes in many guises – some good, some bad. 

Inflation can have many causes. It can be demand-pull or it can be cost-push; it can be broad-based or single-factor; it can be domestically-generated or imported; it can be transitory or permanent.

Each sub-type is visible today in a number of major markets, with the dominant factor varying across economies.

In some instances the pick-up in inflation is a good signal of economic health, in others it is bad news and carries no consoling signal of underlying economic revival; and in still others it is an ugly symptomatic reflection of how the market has taken a gloomy view of the medium-term economic outlook.

We expect the steady build-up of 'good' inflation to continue, given our projections for a modest acceleration of economic growth this year and the potential for fiscal stimulus from the incoming presidential administration.

Which type of inflation we are dealing with is hugely important for long-term strategic investment decisions as managers seek to protect their portfolios from its corrosive effects.

For a few dollars more

Headline CPI inflation in the US has hit a two-year high. While some of that pick-up is due to external factors, there is strong evidence for the build-up of domestically-generated inflationary pressures.

Various measures of core inflation are trending higher, as is services price inflation which typically reflects domestic pressures better than goods prices due to lower import penetration in service sectors.

The rise in core inflation indicates the effect of wage growth on the supply chain as the labour market hits full employment. In other words, the rise in US inflation reflects domestic economic strength.

We expect the steady build-up of 'good' inflation to continue, given our projections for a modest acceleration of economic growth this year and the potential for fiscal stimulus from the incoming presidential administration. 

How should investors respond to that kind of pick-up in inflation?

One way may be to hold an allocation of Treasury Inflation Protected (Index Linked) Securities which could benefit from further inflation surprises.

But other investments address the cause and not merely the symptom of growth-related inflation. Corporate bonds and equities should perform well in this environment, especially in the context of the business-friendly proposals from the Trump administration.

Real estate is another option, as rental prices reflect growing demand amid limited supply. 

Trouble with the curve

The Eurozone story is different. Headline inflation has increased sharply, adding a full percentage point over the past six months, but core inflation has shown little sign of movement and the headline increase can be accounted for almost in its entirety by energy prices. 

This is the antithesis of the good inflation we are observing in the US, even if these energy price effects are visible globally.

It reflects instead an adverse terms-of-trade adjustment that will erode real incomes and purchasing power for euro-area households and corporates. In other words, it is bad news.

How can this be handled? Investors should simply hold their nerve.

Inflation in the UK is rising, partly due to the same energy price effects seen in the euro area.

Headline inflation could move higher still, to 2 per cent, but this will be a temporary effect caused by the distorting base effects of low inflation early last year and should ease in the second half of 2017, as core inflation remains benign given ample economic slack and the possibility of a growth slowdown.

Sudden impact

Now for the ‘ugly’ - inflation in the UK is rising, partly due to the same energy price effects seen in the euro area. 

The UK must also contend with the idiosyncratic shock of a sudden 10 per cent depreciation in the exchange rate in the aftermath of the Brexit referendum which will turbo-charge and prolong the move higher in inflation when it hits retail prices. FX adjustments can take several quarters before they are fully passed through.

Without further shocks, the direction of UK inflation over the next few months is fairly clear.

Less clear is the growth outlook, with much uncertainty surrounding how households and corporates will behave in the face of Brexit.

Our view is that UK growth is likely to slow materially in 2017, leaving investors facing rising inflation and weakening growth. 

How can investors with sterling mandates position their portfolios?

While the market is pricing in rate hikes from the Bank of England (BoE) before the end of next year, there is potential for further easing from the Monetary Policy Committee as the Bank’s gloomy forecast remains intact, despite the recent mea culpa from chief economist Andy Haldane for underestimating the UK economy’s resilience.

While we are not expecting any imminent changes to BoE monetary policy, the chances of a further interest rate cut later in the year being higher than those of a hike.

Equity investors should anticipate weaker growth by favouring defensives, and recognise that Brexit-related moves in sterling are likely to influence the market.

However, more tactically for right now, we believe the current yield on long-dated UK gilts, and in particular inflation-linked securities, is too low.

Equity investors should anticipate weaker growth by favouring defensives, and recognise that Brexit-related moves in sterling are likely to influence the market. 

Into a new phase

We expect the nascent pick-up in inflation across developed markets to continue over the next few months. That transition may revive concerns over how to allocate capital in what will be a very different kind of market environment. 

The key is to understand the varying nature of those different types of inflation – the good, the bad and the ugly – the fundamental sources of those types of inflation and, their likely longevity. By doing so, the challenges presented by the return of inflation can be transformed into investment opportunities.

James Ashley is head of international market strategy at Goldman Sachs Asset Management