BlackRock sees higher inflation ahead and gives ideas for hedging against it.
Since the Covid-19 pandemic went global, inflation has been a recurring question for investors. With the response to the virus resulting in lockdowns and severe declines in economic output, the immediate result, of course, has been low inflation or even deflation. However, there has been speculation that, over the longer-term, inflation may return, ending the past 30-odd years of low or weak inflation, sometimes called “the great moderation.”
The latest such prediction comes from BlackRock. According to the asset manager, from 2025 onwards, the US should start to see inflation in the range of 2.5% to 3%. While this itself is not a historically large figure, it is above the rate seen in the US and other advanced economies in recent years, is above the Federal Reserve’s traditional 2% target, and is way above market expectations. In the case of the latter, BlackRock says that the implied inflation expectation of the market in 2025 is somewhere between 1% and 1.5%.
There are three broad reasons why BlackRock believes inflation will return: Covid-induced cost increases; central banks allowing inflation overshoot; extensive fiscal stimulus.
Covid-induced cost increases, BlackRock says, will likely be the initial trigger for higher inflation. They note: “The Covid shock is driving up costs in contact-intensive services, and could speed up deglobalisation and the remapping of supply chains for greater resilience against a range of potential shocks.”
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The potential reshoring of production will also likely result in higher labour costs, with workers able to demand higher wages. BlackRock says: “Less offshoring could give domestic workers more bargaining power on wages, especially in places where the political pendulum is swinging toward addressing inequality.” Indeed, the offshoring of production to emerging markets in Asia has often been cited as a key reason for the deflationary bias of advanced economies in recent decade – so it makes sense that a reversal of this trend may result in inflation ticking up again.
Curiously, BlackRock also sees the large tech superstar companies as potentially passing on inflation. This is interesting because, alongside globalisation, the rise of tech and e-commerce companies are often given as a key reason for low inflation. However, argues BlackRock, now that these companies have achieved dominant market shares they have strong pricing power. As a result, should production costs increase they will be able to easier pass these costs onto customers – the result being higher consumer prices, or inflation.
Next, BlackRock points to central banks becoming more tolerant of inflation. By this they mean the Federal Reserve moving to a new policy framework in which an average inflation figure is targeted over a specific period of time, with inflation allowed to overshoot.
BlackRock explains: “After having persistently undershot its inflation goal, the Federal Reserve has adopted a new policy framework to deliberately push inflation above target to make up for past misses.” Part of this will also mean the Federal Reserve will be less inclined to raise rates when labour markets are tight – historically, a key trigger for rate rises.
All of this should compound to boost inflation, BlackRock argues. “With the help of higher production costs, we expect the Fed to succeed in lifting inflation above 2%. The Fed essentially has given up two key reasons to raise rates that it previously had: inflation on track to overshoot the target and overheated labor markets. This reinforces our views about upside inflation risks –especially with rising political pressure to keep interest rates ultra-low.”
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To be sure, the Federal Reserve is the only major central bank to explicitly adopt this new policy framework, so far. However, with central banks in most advanced economy undershooting their inflation targets, it is not inconceivable that others will follow in the Fed's footsteps.
Finally, BlackRock is concerned that the huge fiscal expansion of government’s in response in the pandemic, accommodated by low rates from central banks, could spill over into inflation. They note: “We see a risk scenario where major central banks lose grip of inflation expectations relative to their target levels. This is not our base case –but could happen without proper guardrails and a clear exit plan from current stimulus measures.”
What does higher inflation mean for investors?
The first argument of BlackRock is that markets are not yet “pricing in” these higher inflation expectations. As a result, this presents investors with a window of opportunity to reallocate their portfolio. Once inflation does appear, “it’s likely too late for investors to react –markets will have already moved to price in higher inflation expectations.”
However, investors should be cautious of diving into rearranging their portfolios in anticipation of higher inflation. The fact that markets are not pricing in inflation means a lot of very experienced and capable investors do not share the inflation expectations of BlackRock. Inflation may not return anytime soon, meaning investors positioned for it will potentially suffer lower returns.
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However, for those convinced inflation will return, there are several asset classes BlackRock expects to do better. First, they note they are overweight inflation-linked bonds. This makes sense – if inflation rises, the return of such bonds will keep pace.
They also note they expect real estate to do better in a higher inflation environment. They note: “We also like real assets, such as real estate, as potential diversifiers and sources of resilience.”
Certain types of shares may also perform well – particularly those that are able to pass rising costs onto consumers due to being in a dominant market position. As BlackRock notes: “We prefer companies with strong market positions and the ability to pass on higher costs.”
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