As the largest vaccination programme in history commences, risk markets appear to be ignoring the logistical challenges or near-term downside growth risks from tighter lockdowns imposed after infection rates in Northern Hemisphere countries soared over the winter. With the S&P at or close to all-time highs and many investment grade corporate bond spreads trading through pre-COVID levels, financial markets appear to be priced for perfection. The accommodative stance of monetary policy, direct central bank interventions, and a supportive supply/demand technical backdrop should continue to support credit risk appetite. However, financial market pricing most likely reflects monetary stimulus more than economic fundamentals. Since the current stance of developed market central bank policy is predicated on inflation remaining low for the foreseeable future, understanding the path that inflation is likely to take over the coming years will be critical for investment returns. 

Inflation is likely to remain benign, although opposing forces are at play 

An important question is whether the secular trends apparent at the onset of the pandemic are likely to remain the same, accelerate, or reverse and getting this right will determine whether inflation is likely to remain benign or move into a higher regime.

Factors that are likely to be inflationary

Central bank policy: Arguably, monetary policy has been too tight in the past decade as developed market output gaps have closed only gradually. This is likely to change in favour of accepting a higher inflationary impulse with the Federal Reserve (Fed) now pursuing an Average Inflation Target (AIT) and other global central banks pursuing low/negative interest rates and quantitative easing (QE). While large monetary stimulus did not lead to inflation following the global financial crisis (GFC), the current circumstances are quite different. In contrast to the financial crisis, banks are now being encouraged to lend to businesses and consumer balance sheets are far healthier. 

Money supply: Economic theory suggests that rapid changes in the money supply can impact inflation. Global money supply has rocketed in response to the pandemic growing at an unprecedented rate. 

Globalisation: Over the last 30 years, globalisation has been a disinflationary tailwind but has been slowly reversing in recent years, demonstrated by a sustained fall in global trade volumes. The pandemic has highlighted some obvious weaknesses in reliance on foreign supply chains, and continued reshoring of these (some of which will have strategic importance) is likely to be an inflationary force, going forward. 

Factors that are uncertain

Fiscal policy: Higher inflation helps reduce government debt and deficits and so governments have a strong incentive to inflate away debt burdens. In contrast to the post-GFC era, policymakers are concerned that monetary policy has reached its limits and greater emphasis is now being placed on fiscal policy as the main tool to generate growth and inflation. Channelling money to lower-income cohorts could lead to higher inflation as this group generally has a higher propensity to spend. 

Whilst continued transfer payments to those on lower incomes would likely push prices up there is a risk that the urgency for expansionary fiscal policy wanes as the global growth outlook improves. Positive news on vaccine efficacy increases the likelihood that we remain stuck in a world where deficits still matter.

 

Risk factors you should consider before investing:

• This material is not intended to provide investment advice or be considered a personal recommendation.
• The value of investments and income from them can go down as well as up and you may lose some or all of your initial investment.
• Past results are not a guide to future results.
• If the currency in which you invest strengthens against the currency in which the underlying investments of the fund are made, the value of your investment will decrease.
• Depending on the strategy, risks may be associated with investing in fixed income, derivatives, emerging markets and/or high-yield securities; emerging markets are volatile and may suffer from liquidity problems.