Blow-in: why inflation is the new risk in town
Article written by InvestNow – 28th February 2022
Everything is up.
After a decade when monetary authorities were more concerned about deflation rather than out-of-control rising prices, official inflation gauges have risen to levels not seen since the 1980s.
In the US, for example, the most-cited annual inflation measure hit 7.5% this January compared to 1.7% just 12 months previously.
Reserve Bank of NZ (RBNZ) data paints a similar picture here: the annual consumer price index (CPI) increased from 1.4% at the end of 2020 to 5.9% as at December last year.
Confirming the obvious in its February 23 monetary policy statement, the RBNZ highlighted “upside risks to inflation” over the medium term.
“… global inflation is currently higher, and expected to ease more gradually than anticipated in the November [2021] Statement,” the RBNZ February release says. “The Committee noted that central banks are now looking to increase interest rates sooner and by more than anticipated in the November Statement.”
Central banks tolerate – and indeed encourage – a certain dose of inflation with most targeting an annual rate anchored around 2%.
And while inflation was widely expected to rise as economies recovered somewhat from the early 2020 pandemic shock, both the speed and scale of the process has taken central banks and markets by surprise.
Initially, the most powerful central bank of all – US Federal Reserve, or ‘Fed’ – took a relatively benign view of post-COVID prices spikes.
Fed chair, Jerome Powell, famously described the brewing inflation of late 2020 as “transitory”, expecting it to blow over quickly as pandemic-related supply-chain issues eased.
By December last year, however, Powell back-tracked, telling media “it’s probably a good time to retire that word [transitory] and try to explain more clearly what we mean [by inflation]”.
Economists, of course, continue to argue about the nature, cause and potential cures for inflation – both in general and regarding specific cases such as the current bout – but the broad concept is simply understood as “a rise of average prices through the economy”, according to an RBNZ publication.
“It means that money is losing its value,” the RBNZ more brutally puts it.
For most people inflation is less of an academic issue, as those shelling out $3 a litre for petrol or $12.20 for a kilogram of broccoli today will know.
The RBNZ notes the most obvious impact of inflation is that consumers “may be left worse off if prices rise faster than their incomes”.
Trending price increases can also “accentuate boom-bust cycles in the economy”, the RBNZ says, while entrenched inflation can damage long-term economic prospects.
“If money is losing its value, businesses and investors are less likely to make long-term contracts.”
But rapid and sustained general price increases can also “reduce the value of an investment if the returns prove insufficient to compensate them for inflation”, the RBNZ says.
Central banks suck it and see
Given the potentially destructive power of inflation, central banks have long sought to keep price rises in a low and stable range using their weapon of choice: interest rates.
Official interest rates have a strong influence on both inflation (all else being equal, less money circulating in the economy will lead to lower prices) and asset values by setting a benchmark ‘risk-free rate of return’.
Since the 2008/9 global financial crisis (GFC) interest rates have been low and falling; a trend accelerated by the COVID-19 pandemic as central banks and governments combined to fight the threat of economic collapse.
As well as lowering interest rates, central banks – especially in the US and Europe – have employed ‘unconventional monetary policies’ such as quantitative easing (or QE, a process often described as ‘money printing’) to further prop up economies in the wake of the GFC.
Other countries including Australia and NZ, which previously eschewed QE, went all-in on money-printing as COVID-era emergency measures.
With interest rates at historical lows (negative for most jurisdictions in real terms – that is, after inflation) and more money in the system, investors have bid up the prices of almost all assets in the search for higher returns.
However, as central banks move to combat inflation by hiking rates and removing emergency monetary support, market dynamics are also set to change.
Last year, for example, the RBNZ abruptly ended its QE campaign in July before embarking on a rate-hiking cycle a few months later while Australia followed suit this February.
Since October the RBNZ has lifted the official cash rate (OCR) three times in increments of 0.25%. Post the February hike, the OCR is now at 1%, on track to peak at 3.4% in 2025 (a figure revised upwards from the November RBNZ guidance of 2.6%).
Meanwhile, the Fed will halt its multi-year QE program in March, months earlier than anticipated, ahead of a series of expected interest rate increases.
Markets breathe in (and out)
The shifting mood on inflation and interest rates has already flowed over into financial assets, particularly in the fixed income sector.
In fact, bond markets, which are highly sensitive to expected interest rate changes, fell into the red during 2021 as investors braced for hikes: figures from investment consultant, Mercer, show the NZ government bond index was down -6.2% for the year while the global fixed income benchmark returned -1.2%.
Volatility also greeted share markets in 2022 as investors digested the all-important inflation and interest rate news as well as other geopolitical risks including the threat of war in Ukraine and the lingering impact of COVID.
For instance, year-to-date the US S&P500 and Nasdaq 100 indices are down more than 8% and 14%, respectively. The NZ main stock index is also off its 2022 high by almost 7%.
Asset consultancy firm, Melville Jessup Weaver (MJW) noted in its December quarter investment survey that “inflation remains the chief uncertainty” for the year ahead and beyond.
“So far, the stretch of heightened inflation has persisted in New Zealand and in many other countries is running at the highest level seen in decades,” the MJW report says. “Nevertheless, opinion remains firmly divided on whether it can still be classed as transitory. The level of inflation in the coming year will affect the actions of reserve banks as well as the relative appeal of certain asset classes or stocks that, for example, have enough pricing power to maintain their profits in a real sense.”
For investors, the important questions will revolve around both the duration of the current inflationary surge and how aggressive central banks will be in combating it.
A recent study from UK hedge fund firm, Man Group, found in periods of high sustained inflation (above 5% for more than six months) over an almost 100-year period, only commodities and certain actively managed share strategies tend to fare well: both bonds and equities will suffer in such a scenario, the paper says.
But if inflation remains within reasonable bounds, investors could still experience solid returns in other asset classes.
According to a recent Devon Funds article: “Ultimately stock markets can do well during a period of inflation, and as long as it is not allowed to spiral out of control.”
Undoubtedly, active and diversified fund managers – including those on InvestNow – are positioning for an era of higher inflation with both asset allocation and securities selection changes.
But InvestNow general manager, Mike Heath, says self-directed investors probably shouldn’t be making radical portfolio decisions despite the uncertain inflationary outlook.
“This could be a good time for investors to review their investment time horizon, risk tolerance and asset allocation in light of recent volatility and inflation scenarios,” Heath says. “The Sorted Investor kickstarter tool, is a good place to start. Or seek professional financial advice to help you through the downs and ups.”
Blow-in: why inflation is the new risk in town
Article written by InvestNow – 28th February 2022
Everything is up.
After a decade when monetary authorities were more concerned about deflation rather than out-of-control rising prices, official inflation gauges have risen to levels not seen since the 1980s.
In the US, for example, the most-cited annual inflation measure hit 7.5% this January compared to 1.7% just 12 months previously.
Reserve Bank of NZ (RBNZ) data paints a similar picture here: the annual consumer price index (CPI) increased from 1.4% at the end of 2020 to 5.9% as at December last year.
Confirming the obvious in its February 23 monetary policy statement, the RBNZ highlighted “upside risks to inflation” over the medium term.
“… global inflation is currently higher, and expected to ease more gradually than anticipated in the November [2021] Statement,” the RBNZ February release says. “The Committee noted that central banks are now looking to increase interest rates sooner and by more than anticipated in the November Statement.”
Central banks tolerate – and indeed encourage – a certain dose of inflation with most targeting an annual rate anchored around 2%.
And while inflation was widely expected to rise as economies recovered somewhat from the early 2020 pandemic shock, both the speed and scale of the process has taken central banks and markets by surprise.
Initially, the most powerful central bank of all – US Federal Reserve, or ‘Fed’ – took a relatively benign view of post-COVID prices spikes.
Fed chair, Jerome Powell, famously described the brewing inflation of late 2020 as “transitory”, expecting it to blow over quickly as pandemic-related supply-chain issues eased.
By December last year, however, Powell back-tracked, telling media “it’s probably a good time to retire that word [transitory] and try to explain more clearly what we mean [by inflation]”.
Economists, of course, continue to argue about the nature, cause and potential cures for inflation – both in general and regarding specific cases such as the current bout – but the broad concept is simply understood as “a rise of average prices through the economy”, according to an RBNZ publication.
“It means that money is losing its value,” the RBNZ more brutally puts it.
For most people inflation is less of an academic issue, as those shelling out $3 a litre for petrol or $12.20 for a kilogram of broccoli today will know.
The RBNZ notes the most obvious impact of inflation is that consumers “may be left worse off if prices rise faster than their incomes”.
Trending price increases can also “accentuate boom-bust cycles in the economy”, the RBNZ says, while entrenched inflation can damage long-term economic prospects.
“If money is losing its value, businesses and investors are less likely to make long-term contracts.”
But rapid and sustained general price increases can also “reduce the value of an investment if the returns prove insufficient to compensate them for inflation”, the RBNZ says.
Central banks suck it and see
Given the potentially destructive power of inflation, central banks have long sought to keep price rises in a low and stable range using their weapon of choice: interest rates.
Official interest rates have a strong influence on both inflation (all else being equal, less money circulating in the economy will lead to lower prices) and asset values by setting a benchmark ‘risk-free rate of return’.
Since the 2008/9 global financial crisis (GFC) interest rates have been low and falling; a trend accelerated by the COVID-19 pandemic as central banks and governments combined to fight the threat of economic collapse.
As well as lowering interest rates, central banks – especially in the US and Europe – have employed ‘unconventional monetary policies’ such as quantitative easing (or QE, a process often described as ‘money printing’) to further prop up economies in the wake of the GFC.
Other countries including Australia and NZ, which previously eschewed QE, went all-in on money-printing as COVID-era emergency measures.
With interest rates at historical lows (negative for most jurisdictions in real terms – that is, after inflation) and more money in the system, investors have bid up the prices of almost all assets in the search for higher returns.
However, as central banks move to combat inflation by hiking rates and removing emergency monetary support, market dynamics are also set to change.
Last year, for example, the RBNZ abruptly ended its QE campaign in July before embarking on a rate-hiking cycle a few months later while Australia followed suit this February.
Since October the RBNZ has lifted the official cash rate (OCR) three times in increments of 0.25%. Post the February hike, the OCR is now at 1%, on track to peak at 3.4% in 2025 (a figure revised upwards from the November RBNZ guidance of 2.6%).
Meanwhile, the Fed will halt its multi-year QE program in March, months earlier than anticipated, ahead of a series of expected interest rate increases.
Markets breathe in (and out)
The shifting mood on inflation and interest rates has already flowed over into financial assets, particularly in the fixed income sector.
In fact, bond markets, which are highly sensitive to expected interest rate changes, fell into the red during 2021 as investors braced for hikes: figures from investment consultant, Mercer, show the NZ government bond index was down -6.2% for the year while the global fixed income benchmark returned -1.2%.
Volatility also greeted share markets in 2022 as investors digested the all-important inflation and interest rate news as well as other geopolitical risks including the threat of war in Ukraine and the lingering impact of COVID.
For instance, year-to-date the US S&P500 and Nasdaq 100 indices are down more than 8% and 14%, respectively. The NZ main stock index is also off its 2022 high by almost 7%.
Asset consultancy firm, Melville Jessup Weaver (MJW) noted in its December quarter investment survey that “inflation remains the chief uncertainty” for the year ahead and beyond.
“So far, the stretch of heightened inflation has persisted in New Zealand and in many other countries is running at the highest level seen in decades,” the MJW report says. “Nevertheless, opinion remains firmly divided on whether it can still be classed as transitory. The level of inflation in the coming year will affect the actions of reserve banks as well as the relative appeal of certain asset classes or stocks that, for example, have enough pricing power to maintain their profits in a real sense.”
For investors, the important questions will revolve around both the duration of the current inflationary surge and how aggressive central banks will be in combating it.
A recent study from UK hedge fund firm, Man Group, found in periods of high sustained inflation (above 5% for more than six months) over an almost 100-year period, only commodities and certain actively managed share strategies tend to fare well: both bonds and equities will suffer in such a scenario, the paper says.
But if inflation remains within reasonable bounds, investors could still experience solid returns in other asset classes.
According to a recent Devon Funds article: “Ultimately stock markets can do well during a period of inflation, and as long as it is not allowed to spiral out of control.”
Undoubtedly, active and diversified fund managers – including those on InvestNow – are positioning for an era of higher inflation with both asset allocation and securities selection changes.
But InvestNow general manager, Mike Heath, says self-directed investors probably shouldn’t be making radical portfolio decisions despite the uncertain inflationary outlook.
“This could be a good time for investors to review their investment time horizon, risk tolerance and asset allocation in light of recent volatility and inflation scenarios,” Heath says. “The Sorted Investor kickstarter tool, is a good place to start. Or seek professional financial advice to help you through the downs and ups.”
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