By ELKE SPEIDEL-WALZ
IN RECENT weeks, inflation has become the most decisive factor in capital markets and expected asset-class returns. How quick and to what extent inflation will rise will determine the future path of interest rates and asset-market performance. What is our outlook for global inflation and what consequences do we draw for asset allocation?
The short-term outlook is rough, but in the medium term, inflation rates are expected to decline from current high levels. Inflation will be higher and more persistent in the next few years than in the past. In the last five years, inflation was low due to the disinflationary effect of globalisation. World trade and global competition (labour and goods prices) became more intense, while deregulation and strong productivity growth had a dampening effect on prices.
In the next few years, this positive effect will gradually run out. The dampening effect of inflation from globalisation is fading as wages rise, particularly in emerging markets; the risk of new regulations and protectionism emerges; commodity price pressure continues (an inflationary effect of globalisation and strong Emerging Markets growth); and productivity growth declines.While inflation will be higher than in the recent past, we consider a return to the levels of the 1970s unlikely.
The main reason is that global competition and open economies will continue to prevent price-wage spirals, at least in major countries. Central bank credibility has increased substantially and no further inflation pressure stems from fiscal policy, as was the case in the 1970s.
Last but not least, an important reason we see inflation coming down eventually is the growth outlook. Weak internal demand in the US and the Eurozone, falling capacity utilisation and rising unemployment do not create an environment in which higher input prices can easily be passed on.
Nevertheless, in the short term, uncertainty about the inflation outlook will weigh on financial markets. The reaction of inflation to the cyclical situation has always occurred with a significant time lag - 4-6 quarters from the cycle's peak in the past.
Why this lag? Prices are 'sticky' due to implicit and explicit contracts that are expensive to renegotiate. Consideration of competitors' price actions and information costs are other reasons. The most recent peaks in the output gap - the US, UK, Eurozone, Canada and Australia - happened around Q3 2007.
Consequently, from early 2009 we should see the cyclical dampening effect of inflation. As from spring 2009, the base effects from energy prices should also work in this direction, assuming oil prices will at least not be visibly higher than US$130 a barrel. While rising inflation is not necessarily bad for stock markets, the transition phase described above used to be uncomfortable for equities.
How do different asset classes perform under the outlined inflation scenario? The straightforward effect of inflation on asset- class return, as suggested by theory, has to be seen in the context of the current cyclical situation (overheating or growth slowdown) and structural trends that might enforce or counteract the straightforward impact (global competition and price-setting behaviour for goods and labour markets).
The value of adding an asset class to a portfolio stems either from the fact that it directly hedges against inflation or is able to yield attractive returns in times of rising inflation. We summarise the evaluation of the individual asset classes in the accompanying table.
The best inflation hedge is inflation-linked government bonds. The return outlook depends on the extent to which inflation expectations are already priced in and the benchmark inflation index is implemented in the linker (that is, Eurozone-harmonised CPI versus national headline inflation and core rates).
Asset classes that are able to yield attractive returns in the current inflation environment are commodities, hedge funds and real estate. The latter is currently suffering, however, from the ongoing adjustment process in many countries. While stock markets can perform positively in an inflationary environment (assuming central bank credibility), they suffer in the intermediate phase (the tug- of-war between the inflation-dampening effect of declining growth and inflationary effects of ongoing commodity price strength). Infrastructure investments can also offer a partial inflation hedge, depending on the underlying cashflow structure (inflation-linked payments).
The writer is deputy head of investment strategy group, Deutsche Bank Private Wealth Management
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