How worried should you be about inflation?

How worried should you be about inflation?

Inflation at its present level is certainly a concern. It will be more of a concern if inflation stays high over a sustained period. Already we have seen evidence of inflation eating into the disposable incomes of families and reducing the profitability of some companies.

Even so, shares have rallied moderately well since the US stock market dipped into bear market territory mid-month, driven by hopes that markets may have overreacted.

Inflation and, by implication, fears of yet higher interest rates have been behind much of the disquiet in stock markets so far this year, along with concerns the world’s major economies may grind to a halt as interest rate rises take effect.

Recently, the Bank of England (BoE) changed its informal guidance saying inflation could reach 11% by October. That implies price rises will accelerate over the next two to three months.

However, the BoE also says that inflation will be close to 2% in two years[1]. How can this be?

The first reason is purely mathematical. The annual inflation rates that get published each month in 2023 will be based on elevated starting points in 2022. Thus, barring the advent of additional inflationary forces, the annual rate of inflation should fall sharply next year.

Secondly, slowing global growth is already having an impact on commodity prices. Crude oil is down US$18 per barrel compared with its March peak, while the prices of metals like copper and tin have just suffered their worst quarterly falls since the 2008 financial crisis[2].

Finally, the extraordinary pricing conditions of 2021-22 coming from stretched supply chains, the release of pent-up, post-pandemic demand and the war in Ukraine should have relented by the time we get to 2023. The lagged effects of higher interest rates should also be coming into play by then.

In essence, this thinking may have been behind the rallies we have seen in markets over the past week or so which, for example, have taken shares in the US as measured by the S&P 500 Index about 4% off their June lows[3].

Given the severity of the response to worsening inflation data so far this year, there is probably room for both shares and bonds to rally as inflation fears peak.

Medium-dated US Treasuries and UK Gilts are now yielding 2.9% and 2.2% respectively, showing predictable returns are making a comeback[4]. This could start to look appealing to income seekers if UK inflation is, indeed, headed to 2% in two years’ time.

A key danger for shares is that the effects of inflation and higher interest rates start to drive a bear market in corporate earnings. However, for the time being at least, companies appear to be coping quite well.

In the current environment of rapidly changing expectations about where the global economy is headed next, it makes more sense than ever to maintain a diversified investment portfolio.

That normally means holding investments in both bonds and equities, as their returns tend to diverge from one another over the short term. A multi-asset fund is one good way of achieving this.

Sources:

1 Bank of England, 16.06.22
2,3,4 Bloomberg, 04.07.22

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