Why inflation risk should be top-of-mind right now

Raf Choudhury

State Street Global Advisors

The big talking point in the market now is inflation. Over the last 40 years, inflation has been generally contained within or below the targets set by central banks, but recent signs point to higher levels of inflation around the world. Investors are taking note because inflation has a direct impact on the purchasing power of every dollar we earn.

  • Supply bottlenecks because of COVID may lead to higher inflation risks as the global economy reopens.
  • Bond markets are pricing in higher than target levels of inflation, with US 5-year break evens peaking in May.
  • Commodities across the board have seen record rallies over the last 12 months.
  • Investors should be thinking about how to manage the inflation risks in their portfolios.

As prices rise with inflation, it costs us more to buy goods and services – which, in turn, means a decline in the value of every dollar we have. Central banks also keep a close eye on inflation as rising prices could force central banks like the US Federal Reserve (Fed) into raising interest rates. There are additional pressures as well.

In March, US President Joe Biden signed a US$1.9 trillion economic relief bill that saw the government send US$1,400 cheques to most Americans. With increased levels of savings through the pandemic, consumers are itching to get out and enjoy some retail therapy.

The economic reopening, along with a pickup in retail sales, could drive prices higher. Financial markets are also pricing in a post-COVID economic recovery and the potential for “reflation”.

Long-term bond yields are up and have been on the rise since the start of the year. The yields on the 10-year bond in both the US and Australia have risen by around 55 basis points and the 20-year bond in the US by around 65 bps.

Yields are expected to rise if markets anticipate higher levels of inflation going forward. This is because investors purchasing power is eroded by higher inflation – so they will demand higher yields to compensate for the inflation risks they see on the horizon. And there are more direct signals in the market. The US 5-Year Breakeven Inflation Rateb which reflects a measure of expected inflation, peaked mid-May 2021 at just under 2.8 and ended the month at 2.4, still above the average target set by the Fed of 2%.

There are other signals that inflation is picking up as well. Some argue that the current pick-up in inflation (the 12-month percentage change in the US consumer price index was around 5% as of the end of May), is transitory and point to events like the temporary closure of the Suez Canal in March this year. That was significant not only because it saw a container stuck for six days, but because 12% of global trade passes through the shipping lane, so this is likely to have caused significant short term supply chain disruption.

Other signals can be found in the breakdown of the inflation figures themselves. The 12-month percentage change in the energy component of the US Consumer Price Index was 28.5%.

And it’s been commodities – often regarded as an inflation indicator as well as an inflation hedge – that have seen a rapid rise in prices over the last 12 months. Across the board, the rise in commodity prices to the highest levels since the start of the pandemic is creating increased cause for concern.

At some stage, the increase in raw materials will feed through to an increase in the price of final products. Going forward, central bankers must decide whether they can keep looking past the signs indicating higher levels of inflation and decide if they need to move faster to cool demand through rate rises and other moves.

With the economic recovery underway, we will probably now see two rate rises by the end of 2023, but that is over a year away. In the interim, higher prices for raw materials will likely result in temporary inflation pressures and we expect to see inflation settle slightly higher than investors may be anticipating.

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Head of Investment Strategy & Research - Australia
State Street Global Advisors

Raf is Head of Investment Strategy and Research for Australia. In this role he is a seasoned speaker and commentator on a range of investment related issues. Key focus areas are asset allocation and portfolio construction as well as product ...

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