Inflation is next nerve-jangler for investors

October 18, 2016

The author is a Reuters Breakingviews columnist.  The opinions expressed are her own.

After undershooting inflation targets for years, Bank of England Governor Mark Carney and some of his global peers are now talking about tolerating overshoots. The volte-face will necessitate nimble investor footwork. While bonds would be obvious losers, the winners will depend on whether inflation is of the good or bad variety.

The former occurs when rising wages mean consumers are willing to pay more for the same goods. The less desirable sort materialises when an external shock forces suppliers to charge more, regardless of demand, as during the 1970s oil price shock. Unilever’s dispute with UK retailer Tesco last week over the price of its consumer products, including yeast-based spread Marmite, gave an early taste of the latter kind.

For fixed-income investors, there’s not much difference between the two. Inflation, of whatever variety, erodes the real value of returns. Aside from inflation-linked bonds, most kinds of debt fall in value when inflation accelerates.

But matters are less clear cut when it comes to other asset classes.  For example, consumer discretionary stocks are better placed to benefit when inflation is rising, because households are splashing out and the economy is growing faster. Less so when outside forces boost inflation. This could be the case in Britain, where a sharp fall in sterling is making imports more expensive.

Investment strategies that traditionally benefit during times of higher inflation may also founder if rate-setters react more slowly to rising inflation than in the past. For instance, the relative performance of real assets, such as property, has traditionally moved in sync with U.S. policy rates since the 1950s, Bank of America Merrill Lynch analysts say. But this relationship may be weaker if there’s a longer lag than usual between rising inflation and monetary tightening.

Both U.S. and UK headline inflation picked up, data showed on Oct. 18. Carney says he is willing to allow inflation to run “a bit” higher than his 2 percent target in order to help employment and growth. And investors think Federal Reserve Chair Janet Yellen might be inclined to do the same after she said on Oct. 14 that running a “high pressure economy” may be one way to reverse crisis-era scarring that was at risk of becoming permanent. If so, money managers may find it as tricky to navigate inflation risks as they did the threat of deflation.




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