Following last week’s news that US inflation hit close to a 40-year high, investors are being warned that inflation is no longer “transitory”.
US Consumer Price Inflation (CPI) hit 6.8% in November, which was not only the largest one year increase since 1982, when a certain Ronald Reagan was President, but also considerably up from 6.2% recorded in October.
Chris Metcalfe, managing director at Iboss, noted that there are numerous tailwinds behind the rapid increase in inflation and more crucially, rather than being “transitory” as has often been suggested, it is instead here to stay.
“It has to be a possibility that we have an inflationary explosion caused by record amounts of fiscal stimulus colliding with super-loose monetary policy and hitting substantial pent-up demand,” he said.
“Whilst retiring the word transitory is at least an acknowledgement of economic reality, it will need to be followed up with actions,” he added. “Most importantly for investors, what will the Federal Reserve response be if equity markets fall in response to their actions?”
For Metcalfe, if the Fed does not act somewhat more aggressively than is currently price into markets and inflation keeps spiralling upwards, at some point their hands will be forced. This, he added, could be very bad for risk assets.
“As record amounts of retail money have flowed into US equities, a sell off in tech caused by interest rate rises could be more significant than at any time since the end of the dot.com bubble,” he warned.
“Suppose, then, they do act sooner rather than later,” he added. “In that case, this could also be bad for those very same assets which have prospered over the last decade as so many investors are treating the current market conditions as though they will persist indefinitely.”
A third case scenario is that economic growth gently rolls over, inflation subsides and the Fed never really acts. In this case, Metcalfe said while the party can continue it will hit earnings and ultimately cannot be good for risk assets other than those that can potentially thrive on lower forever interest rates.
“The reason the IA multi-asset sectors are having their best rolling year ever is because we have reached either maximum optimism or maximum greed,” he said. “It seems to us that when you have valuations such as that of Tesla, Faanmgs making up over 25% of the S&P and rapidly rising inflation, we should be proceeding with caution.”
“Something will deflate the everything bubble, and we have to hope that the central banks led by the Fed play the game of their lives,” he added. “Hope, however, is not an investment strategy, and the data says it’s going to be a tough fight for them.”
While most central banks believe inflation will prove temporary, Yoram Lustig, head of multi-Asset solutions, EMEA & Latam at T Rowe Price, believes prices could remain elevated for an extended period – perhaps too long for authorities not to act.
“This is likely to be a key theme in 2022,” he said. “For more than a decade, inflation has not been regarded as a major investment risk. Indeed, since the global financial crisis, deflation has been seen by many as a bigger threat. However, inflation is proving to be a bit more persistent and higher than many expected, putting pressure on some central banks around the globe to act.”
In terms of portfolio positioning, T Rowe Price’s multi asset team remains modestly underweight in equities – relative to bonds and cash – as Lustig said valuations look less compelling amid moderating growth and stimulus.
“Higher rates, rising input costs, spiking energy prices and potential tax increases could pose challenges to the near term earnings outlook for equities,” he said. “Within fixed income, we continue to favour shorter duration and higher yielding sectors, with overweights to high yield bonds and emerging market debt.”