BMO Global Asset Management: Inflation on the up – should we be concerned?

Scott Spencer, Investment Manager in the Multi-manager team at BMO Global Asset Management comments on the Office for National Statistics (ONS) inflation data released today and asks if investors should be concerned

“The Consumer Prices Index including owner occupiers’ housing costs (CPIH) rose by 3.0% in the 12 months to August 2021, up from 2.1% in the 12 months to July. As recorded by ONS, the increase of 0.9 percentage points is the largest increase ever recorded in the CPIH National Statistic 12-month inflation rate series, which began in January 2006. Should investors be worried about a sustained inflationary trend or is the rise a transitory one? It’s been one of the single biggest worries for policymakers, economists and financial markets for months, fuelling volatility in equities and rattling bond investors.

Inflation: how high will it go and how long will it last?

“While there has been clear evidence that, as measured by consumer prices, inflation has been on the up in recent months, we’re not convinced that the increase will be sustained. Indeed, with recently published data showing that the UK’s GDP growth began to slow, it’s tempting to argue that it won’t be long before investors shift their focus again and start to fret that the recovery has run out of steam.

Why is inflation a concern?

“It’s undeniable that markets are worried. If inflation persists, it could spur the Bank of England (BoE) to lift interest rates to quell rampant economic growth. The concerns are not new, but investor unease is the highest it has been for around 15 years. In broad-brush terms, rising inflation tends to be seen as bad news for markets. For equities, it can make it harder for companies to increase their earnings growth and, with bonds, it can make the securities that investors hold feel less valuable. If interest rates go up, it makes the returns available on newly issued bonds look more attractive.

Being selective matters

“Within this, though, the performance of specific assets can vary dramatically, underscoring the importance of stock and fund selection. When inflation is low, as has been the case for more than a decade, the best returns have tended to be found in growth stocks, longer-term and fixed-rate bonds, for example. Assets that tend to do well when inflation is rising include so-called value stocks, whose intrinsic worth might not be recognised by the wide market, and alternative assets such as property funds and commodity funds that have a clear link to rising prices.

We believe higher inflation is temporary – but remain watchful

“Both arguments favour the view that the recent rise in inflation is temporary. There are complicating factors. A widespread recovery in the labour market, if it leads to a jump in wages, could cause a renewed bout of inflation driven by a rapid rise in demand for goods. Employees tend to spend their extra earnings, which increases the amount of money circulating in the economy and acts as a further inflationary pressure. This kind of inflation could be more prolonged. It’s nuanced, but now for us the argument that rising inflation levels are transitory is winning the day. We need to stay watchful, though, particularly for signs of a growing appetite to borrow among consumers, which could also push up prices over the longer term. In this environment, the key for fund managers is to be flexible, and to be prepared to adapt the contents of their portfolios as and when the inflation data and the leading indicators change.”

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