When it comes to inflation, investors shouldn't be complacent

The decline in US inflation since last June has given equity markets a shot in the arm over the past few months. Inflation expectations as derived from inflation-indexed bonds point to consumer price-growth of around 2.5% starting in June, and then a stabilisation at pretty much that level for years. This outlook is akin to a return to the market conditions we saw in the 2010s, when real yields were largely supportive of financial-asset and property prices and made it easy for passive investors to book gains. We don’t believe in this scenario of lastingly low inflation. On the contrary, we think high inflation will be with us for a while.

There’s mounting evidence that developed-world economies are entering an extended inflationary phase of the business cycle – a phase in which supply will struggle to keep up with demand. We’re in for a rapid succession of inflationary growth spurts driven by structural factors, followed by disinflationary slowdowns orchestrated by central banks. This will bring renewed cyclicality to the economy, which is bad news for passive investors. It also means we need to take a fresh look at investment themes that had fallen by the wayside when the business cycle disappeared.

This dearth of workers, combined with high energy prices and rising interest rates, is the most likely reason behind the current slowdown in GDP growth. And economic slowdowns resulting from depressed supply are necessary inflationary. They also make steering monetary policy more complicated. Here, it’s interesting to note that the US Federal Reserve’s recent round of rate hikes, of an unprecedented pace and magnitude (475 basis points in 10 months), coincides with the lowest US unemployment readings since 1969.

In the near term, the battle against inflation will be won with a few more rate hikes, as they’ll probably trigger the recession needed to put the brakes on price growth by undermining demand. But they won’t address the issue of depressed supply. The societal and economic aspirations of today’s consumers mean we’ll see a succession of inflationary growth spurts, pointing to a longer struggle against inflation than the consensus seems to expect. These aspirations are shrinking the pool of workers and lifting energy prices, and their effects will be countered only sporadically by fiscal and monetary policy, since the pain threshold in advanced economies is so low. The recessions orchestrated by these policymakers to stymie inflation will be short-lived and shallow. Expect consumer price growth to be resilient – it’ll fall, but it’ll get back up again every time.

At Carmignac, our fixed income team has been successful in taking advantage of movements in sovereign and corporate bond yields amid a higher-interest-rate environment, in spotting asymmetrical investment opportunities in emerging markets, and in effectively managing our portfolios’ interest-rate sensitivity on both the positive and negative side. These skills will be particularly advantageous in the current economic climate.

Real interest rates are expected to remain low, which will support equity markets and warrants significant exposure to gold. China offers attractive diversification potential given the lack of inflation in the country for now.

We plan to introduce an inflationary bias in our portfolios in order to take advantage of the many opportunities that the increased cyclicality in the economy will offer, while providing for the necessary diversification. We’ll invest with strength and conviction – and with inflation as our ally.