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Is inflation investors’ number one risk?

George Trefgarne explains why investors should keep a close eye on inflation at present.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

Stock markets have been buoyant, touching record highs in the United States, and the FTSE 100 has gone through 7,000 for the first time since the pandemic took hold.

But this week stock markets dropped sharply, on fears of rising inflation.

On Wednesday, official figures showed that in April US consumer price inflation came in at 4.2%, the fastest since 2008. This was even worse than the market expected.

In my view, inflation is the number one risk investors need to consider right now. There’s also the related issue of potential rises in interest rates to bring it under control.

The question is, will this be a temporary blip or something longer lasting, like we saw in the 1970s?

Why might inflation take off?

Inflation is usually caused by excess demand for goods and services, and it’s exacerbated by low interest rates. These are the conditions we’re seeing right now.

Global supply chains are constricted by the pandemic. But the supply of money is abundant, thanks to stimulus packages from both governments and central banks. President Biden is spending $4 trillion in stimulus programmes. It stands to reason that inflation could take off.

Bond markets – the canary in the mine?

Institutional investors are worried. A record net 93% of investors polled by Bank of America in April expect higher inflation. The biggest risk they identified as a result is a “bond market taper tantrum”.

What they mean by this is that they fear a sharp fall in bond markets. Inflation erodes the value of money and it causes investors to change their expectations of future returns. It also triggers fears of a change in central bank policy. This could be winding down quantitative easing programmes (essentially, printing money) higher interest rates, or both.

Central banks use interest rates to keep inflation at a target level – in the UK this is 2%. Rising inflation could prompt central banks to raise interest rates, slowing the economy down and reducing inflationary pressures.

A limited sell-off in the bond market has already occurred, as investors adjust their expectations. Falling bond prices lead to higher yields. The yield on 10-year gilts has more than doubled since the beginning of the year to 0.8% – though this is still very low by historic standards. The equivalent for US Treasury Bonds has hit 1.74%.

Central banks say they’ll tolerate inflation

It’s not just professional investors who are warning about inflation. Central banks themselves have said they will tolerate a temporary spike in inflation as a price for getting the economy moving.

The chairman of the US Federal Reserve, Jay Powell, effectively signalled a change in policy in March to target “an average of 2%”. He said he would set policy “to achieve inflation moderately above 2% for some time to make up for the dramatic drop last year, when the economy plunged into a recession.

Previously, the Fed had a policy of seeing off inflation before it occurred.

Last week the Bank of England said it expected inflation to run temporarily above target next year. But despite this, it held UK interest rates at 0.1% and continued with its quantitative easing programme, although at a slightly slower rate.

What about commodities?

Unsurprisingly, with many economies opening up after the pandemic, some prices are already soaring, especially commodities. We have seen record highs in copper, iron ore and lumber.

House prices are also rising strongly. According to Nationwide, house prices rose 2.1% in April, the biggest monthly rise since 2004.

But the oil price – a traditional cause of inflation – remains relatively low at around $69 per barrel for Brent crude. Energy markets are subject to their own dynamics, including the rise of renewables and lower demand, as many airlines remain partially grounded.

This leads us to the main issue with the forecasts for higher inflation. So far, they’re mostly based on higher asset prices. There’s only limited evidence of it in consumer price inflation figures. These are distorted by the depressed inflation of last year’s recession.

The Office for National Statistics said that inflation, including housing costs, was running at an annual rate of just 1% in March, up from 0.7% in February. There’s also an argument that new technology and spare capacity will make any inflationary spike short-lived.

Will the FTSE 100 offer some shelter for investors?

When it comes to society as a whole, inflation is a disease which can have serious consequences. As Agustin Carstens, the General Manager of the Bank of International Settlements warned recently, bouts of high inflation and recessions hit the poorest and those on lower incomes hardest.

That ‘s because workers struggle to make sure their wages keep up with price rises.

Investors are in a more fortunate position. Periods of high inflation can lead to surges in share prices.

The FTSE 100 index has lagged other stock markets in recent years, in part because it’s full of old-fashioned names like big commodity producers (BHP Group and Rio Tinto), energy groups (Royal Dutch Shell and BP) and banks (HSBC, Lloyds and Barclays). But these companies’ profits could benefit from higher prices or higher interest rates, thus providing some shelter for investors. Taken together, commodity, energy and bank stocks make up more than 27% of the index. Their time may have come again though of course there are no guarantees.

Remember, all investments can fall as well as rise in value, so you could make a loss. This article isn’t personal advice. If you’re not sure what’s right for you, seek advice.

FTSE 100 – annual percentage growth (with dividends reinvested)
April 16 -
April 17
April 17 -
April 18
April 18 -
April 19
April 19 -
April 20
April 20 -
April 21
FTSE 100 performance (with dividends reinvested) 16.7% 7.8% 3.0% -20.7% 18.1%

Past performance isn’t a guide to future returns. Source: Lipper IM, to 30/04/2021.

George Trefgarne is CEO of Boscobel & Partners, a political consultancy. Hargreaves Lansdown may not share the views of the author.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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