Inflation could be the next big risk for investors

SINGAPORE'S inflation data for March, released this past week, hewed to a global trend that has been making some market watchers nervous.

The headline consumer price index (CPI) climbed 1.3 per cent year-on-year in March, a significantly faster rate of increase than the 0.7 per cent recorded for February and the 0.2 per cent for January.

The Monetary Authority of Singapore's (MAS) core inflation rate (which excludes the accommodation and private transport components of the CPI) came in at 0.5 per cent for March, up from 0.2 per cent in February and minus 0.2 per cent in January.

This acceleration in inflation has been attributed by some analysts to the lower base during the Covid-19 downturn last year, and higher oil prices.

MAS and the Ministry of Trade and Industry (MTI) also noted in a statement last week that domestic price pressures could "pick up and broaden across the CPI basket as labour market conditions improve and private consumption recovers".

But these inflationary pressures are likely to be transitory, according to MAS and MTI. The way they see it, oil prices will likely be capped by surplus production capacity, and domestic wage growth curtailed by slack in the labour market. Commercial rents are also projected to stay low.

MAS and MTI are expecting core inflation for 2021 to average between zero and one per cent, and headline inflation to come in between 0.5 per cent and 1.5 per cent.

Letting inflation run

Major economies around the world are also experiencing accelerating inflation as economic activity re-starts after the Covid-19 lockdowns and restrictions.

In particular, US headline CPI for March rose 2.6 per cent year-on-year - a faster rate of increase than the 1.7 per cent and 1.4 per cent reported for February and January, respectively.

Much like their counterparts in Singapore, policymakers in the United States seem to think the recent acceleration in inflation will not persist.

Certainly, the US Federal Reserve appears to be in no hurry to shift its ultra-loose monetary stance.

Fed chair Jerome Powell defended its current policy in a widely publicised letter earlier this month to Republican Senator Rick Scott, who has been sounding the alarm about rising inflation.

The Fed slashed rates to almost zero last year in the face of the Covid-19 pandemic. It is also purchasing at least US$120 billion worth of Treasury and mortgage-backed securities every month.

The Fed is widely expected to maintain this policy until inflation exceeds its 2 per cent target for a period of time.

This aggressiveness is informed by repeated attempts at normalising its monetary policy in the past that proved premature.

In 2013, the Fed broached the topic of winding back its quantitative easing programme. This touched off the "taper tantrum". More recently, in 2018, the Fed pushed through four rate hikes, which triggered a broad market sell-off that forced it to change tack and begin cutting rates the following year.

Inflation has actually been on a secular decline in the US since the 1980s. Some analysts have attributed this to US companies turning to automation and globalised supply chains, which made it harder for American workers to demand higher wages.

Markets nervous

Whatever the reasons for subdued inflation over the last few decades, some analysts now fear that policymakers have become complacent and are underestimating the inflationary pressures that will accompany the post-Covid-19 recovery.

Among them is David Roche, president of Independent Strategy, whom I have watched since the 1990s. This past week, Mr Roche told CNBC that US inflation could accelerate quickly in the months ahead. This would have major implications for financial markets.

"My own view is that we will see inflation of probably 3 or 4 per cent by the middle of next year and that is completely inconsistent with, say, US 10-year bond yields being at 1.6 per cent. That yield could easily double, and when it does, then you come to the crunch point that markets are going to experience," he said during a TV interview.

The markets might already be reflecting widening expectations of higher inflation. The 10-year US Treasury yield has risen from well below one per cent last year to nearly 1.6 per cent currently.

Meanwhile, Schroders pointed out in a research note this past week that five-year inflation expectations, as implied by the yield difference between nominal and inflation-protected US Treasury bonds, have climbed to 2.5 percentage points - their highest level since 2008.

Where to invest

So, what does all this mean for investors?

On the one hand, accelerating inflation and rising interest rates are often associated with booming economic activity and robust corporate earrings - all positive for the market.

On the other hand, in a high inflation environment the market would naturally discount future cash flows at higher interest rates. Consequently, stocks might be expected to trade at lower price-to-earnings (P/E) ratios.

According to Schroders, much depends on whether the economy is perceived to be overheating and inflation running too hot.

Using data going back to 1973, the fund management firm found that US equities outperformed inflation 90 per cent of the time when inflation was below 3 per cent and rising.

When inflation was above 3 per cent and still rising, however, US equities outperformed inflation only 48 per cent of the time.

When inflation was declining, US equities outperformed 76 per cent of the time when inflation was above 3 per cent and 81 per cent of the time when inflation was below 3 per cent.

Schroders also found that the supposed inverse relationship between inflation and P/E ratios was real - the higher the rate of inflation, the lower the P/E ratios that stocks managed to garner in the market.

But Schroders found this relationship to be stronger the higher the rate of inflation. At inflation rates of less than 3 per cent, the relationship was ambiguous.

While stocks did not perform well in general during periods of high and rising inflation, certain sectors did relatively well.

In particular, energy stocks beat inflation 71 per cent of the time and delivered an annual real rate of return of 9 per cent. This is not surprising given that energy prices are a key component of most inflation indices.

Real estate investment trusts also did well during inflationary times, according to Schroders. They outperformed 67 per cent of the time, and posted an annual real return of 4.7 per cent. This is perhaps a reflection of the real assets they are sitting on.

On the other hand, technology stocks performed relatively poorly. With the bulk of their cash flow due to arrive in the distant future, these companies are worth less as inflation rises.

Financial stocks performed somewhat better, because their cash flows tend to be concentrated in the near-term. But high inflation would erode the present value of loans that will be paid back in the future.

Interestingly, although gold is said to be a natural inflation hedge, companies in the mining and precious metals fields delivered an uneven performance during times of high inflation, Schroders noted.

These companies beat inflation only 47 per cent of the time, but they posted an average real return of 8 per cent.

Investors should pay close attention to CPI data at home and abroad over the next few months, and stay alert to the possibility that the current acceleration in inflation proves to be less transitory than policymakers hope.

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