Polaroids, floppy disks, Walkmans and phone books. There is an entire generation today for whom these items are mostly alien - consigned to the past thanks to the wisdom and technology of our age. Is global inflation such a quaint relic? With only one of the last 35 calendar years exhibiting inflation of above 5% in the US (and New Zealand’s recent experience also subdued), one could be forgiven for thinking so. Or perhaps it is a dormant creature waiting for its moment to pounce – a scenario gathering some credence as certain commodities show price strength and the US 10 Year Treasury Note lifts to a 3% yield.
This article assesses the broad inflationary forces at work and concludes that, rather than assuming a continuation of the recent past, investors would do well to ensure their portfolios are “fit for purpose” under a variety of future inflation scenarios.
For some observers, the runaway levels of inflation observed in the 1970s and 1980s are unequivocally a problem of the past. To this way of thinking, a combination of central bank independence, structural reductions in the strength of organised labour, decreasing reliance on fossil fuels and improvements in technology that lower consumer prices, makes inflation more controllable by policymakers and essentially caged.
At the other end of the spectrum are those who argue that inflation is almost inevitable as unemployment reaches secular lows in the major developed countries, reversals in demographic trends increase dependency ratios in coming decades, and central bank policy remains extremely stimulative in a historical context.
Inflation is a complex phenomenon driven by many interacting forces within an economy, and some of these relationships are not well understood. Consequently, we are cautious about making bold predictions about the level or direction of inflation over time. We do believe, however, that there is evidence that the balance of inflationary and disinflationary forces is shifting, such that there are an increasing number of plausible scenarios in which inflation could move meaningfully higher than current levels in developed economies.
Inflation and wages – and by extension the labour market – are intertwined. For the last few decades, the increasing globalisation of the labour market has acted as a disinflationary force as it has opened up cheaper labour markets in emerging economies. This has reduced the bargaining power of workers in developed economies and exerted downward pressure on both salaries and prices.
The influence of this relationship may wane as previous sources of cheap labour in Asia, Latin America and Eastern Europe experience rising wages and standards of living, and the options for low-cost labour outsourcing diminish. Although there may be scope for further trade liberalisation to drive production costs down globally, there is perhaps a greater chance of moves in the opposite direction (deglobalisation) given the current tensions surrounding international trading relationships.
Fewer workers, more retirees
Another inflation driver with a long-term trend that may be changing direction is global demographics – in particular, the proportion of the total population that is working versus the proportion not working (known as the dependency ratio).
There is a lively debate around how changes in the dependency ratio may affect interest rates and inflation, but a compelling argument centres on the supply and demand for goods and services. The argument is that children and retirees (the dependent population) contribute only to the demand for goods (via consumption), while the working-age population contributes to both the demand and supply of goods (via consumption and production). The dependent population, therefore, provide an inflationary impulse in the economy, while the working-age population will tend to be a disinflationary force.
United Nations population projections suggest that we are at, or close to, a turning point in the global dependency ratio. This could turn a longstanding disinflationary force into an inflationary one over time.
In addition to the structural drivers discussed so far, a further inflationary impulse arises from cyclical pressures in the current economic environment. Although low unemployment and strong global growth can, to some extent, be offset by tightening monetary policy, cyclical forces are arguably more inflationary today than at any time since the Global Financial Crisis. This is particularly true in the US, where fiscal stimulus is being applied via tax cuts and expenditure when the economy is already facing late-cycle inflationary pressures.
In counterpoint to the dynamics highlighted above, it is worth noting that technology is likely to remain a powerful disinflationary influence for decades to come, as the prospect of rapid increases in automation places downward pressure on wages and production costs.
Managing the risks
The discussion above illustrates that the balance of inflationary and disinflationary forces in the global economy may be changing, and arguably inflation risks are skewed toward the upside from a cyclical standpoint. When assessing their portfolios, investors should take care to avoid biasing allocations in a way that assumes a continuation of past trends. In practice, this entails investors making a clear assessment of how exposed they are to higher-inflation scenarios.
Inflation-sensitive investors holding portfolios dominated by broad market equity and fixed interest bonds could consider diversifying both their growth and defensive allocations. Within growth portfolios, real assets such as commodities, property and infrastructure – both listed and unlisted – may provide some degree of inflation protection. Within defensive portfolios, inflation swaps, inflation-linked bonds, shorter-duration bonds and floating-rate assets are likely to prove more robust under higher-inflation scenarios than traditional fixed interest government and corporate bonds.
Whether the inflation “beast” will rear its head is a story still unfolding; yet, like all threats to investment outcomes, it is a risk best prepared for.
David Scobie is Head of Consulting at Mercer Investments, based in Auckland. He advises institutional clients on their investment policies, portfolio structures and fund manager selection.
This article does not contain investment advice relating to your particular circumstances. No investment decision should be made based on this information without first obtaining appropriate professional advice and considering your circumstances.