Anybody on a fixed income knows all too well that high inflation means a drop in living standards. So, the recent pickup in inflation has investors asking if we are on the verge of a new inflation era that justifies a new investment approach.
This leaves investors facing one of two risks, depending on what happens to inflation and how portfolios are positioned. The first risk is that investors fail to prepare for high inflation and find their income and wealth fall in real terms.
The second risk is that investors mistakenly prepare for higher inflation only to find that it stays low, and they suffer unusually large losses in the next economic and profits crisis because they have sold all of their defensive assets that can offset large equity losses.
So, what can we tell about the future of inflation from the latest data?
The recently released September CPI data shows 12-month CPI inflation of 3.1 per cent in comparison with 3.2 per cent in August.
The Bank of England has emphasised the temporary nature of many key contributors. These include base effects, which overstate the trend because they compare today's prices with the temporarily depressed price levels of August and July 2020.
Prime examples include the effect of government subsidies and tax cuts such as the Eat Out To Help Out scheme, which resulted in an effective reduction in actual prices paid for meals, but which has since been reversed.
Thus far, the BoE has not raised interest rates, with “upward pressure on CPI inflation expected to dissipate over time” based on their views about the easing of supply disruptions, rebalancing of global demand and the future path of energy prices.
Covid effects
It can also be argued that pandemic effects explain most of the really big price moves and that these are unwinding. As the pandemic took hold, lockdowns crippled incomes, spending collapsed and production halted. Prices fell or flatlined.
The easing of lockdowns then combined with vaccine roll-outs and government support to fuel a blazing recovery in demand at a time when there were shortages due to pandemic shutdowns.
This drove the spike in used-car sales, with the lack of semiconductors curtailing new car production. Container ship shortages and bottlenecks added a further constraint.
Labour market statistics have been heavily affected by the furlough scheme. Initially, it prevented the blowout in unemployment rates and plunging wages you would expect to see in a deep recession.
It did this by removing people from the workforce, but its unwinding has been swelling the workforce, dampening future wage increases, falls in unemployment rates and labour shortages.
The case can also be made that high inflation is becoming more likely, not less likely.
Central banks have tweaked their mandates to be more tolerant of inflation overshooting targets and have kept in place extreme levels of stimulus, even in the face of surging inflation pressures and economic rebounds.
The ingredients are present for a policy mistake with high levels of debt incentivising governments to keep interest rates as low as possible for as long as possible, in order to prevent a blowout in interest payments.
Government spending levels also remain very high in the UK and in most major economies. More government spending is needed to meet carbon emissions targets.
Temporary shortages are lasting longer than expected for two essential inputs to traded industrial and consumer goods: container shipping and semiconductors. Both are putting upward pressure on costs and prices.
High inflation
All of this has propelled inflation to the upper end of the range for the past quarter century, of 1 to 3 per cent a year. Even so, we are still some way off the levels of inflation that have troubled investors in the past.
Our own long-term studies showed that when UK inflation averaged 4 to 6 per cent a year, multi-asset portfolios suffered, as equity returns failed to keep up with inflation.
The transitions to these high-inflation eras coincided with more than just powerful economic recoveries. There were either wars or revolutions that smashed trade and created scarcity, or fundamental shifts in government policy away from keeping inflation low and stable.
Eventually consumers and businesses upped their expectations of future inflation and set in motion self-reinforcing cycles.
High-inflation outbreaks are uncommon and your chances of correctly forecasting such big structural shifts are not high. What makes it challenging is the complexity of our highly integrated, multipolar global economy and the slow-moving nature of structural changes.
There is scant evidence of forecasters getting these big calls right and far more evidence of them getting it wrong.
So, instead of basing your investment strategy on an inflation view, you can use two strategies to tilt the odds in your favour. The first is to bias portfolios to better value opportunities that have a bigger margin of safety priced in.
These investments are more likely to provide higher returns and offset any higher inflation. Our research flags energy equities, UK equities and emerging market bonds as attractive, and these feature in our Morningstar managed portfolios and multi-asset funds.
The second is to test portfolios for a wide range of different economic and market scenarios, not just high inflation. This can reveal which scenarios are best and worst for performance as well as less obvious sources of diversification.
From this type of analysis, we can still see a role for high-quality government bonds in specific deflationary shocks. Foreign currency is also effective as a diversifier against UK-specific inflation risks such as Brexit-related impacts on labour costs and imported goods prices.
While inflation pressures are building, the hallmarks of a high-inflation environment are not present today.
Instead of trying to guess what inflation will do next, investors are better served by building portfolios of the most attractively valued investments they can find and the least expensive diversifiers.
Mike Coop is chief investment officer, EMEA at Morningstar Investment Management Europe
