Introduction

Inflation has become a hot topic in recent months, with news headlines showing annual rates of change in the US Consumer Price Index (CPI) rising above 5% for the first time since 2008. Prior to that it was 1991. Since the 1970s and early ‘80s when inflation peaked at 14.6%, the US Federal Reserve has kept inflation at bay, and managed to meet the target of around 2% annually over the last three decades, with the occasional peak or valley. Indeed, the consistency of low inflation has been a prominent feature of the US economy since the early 1990s.

Should we be concerned about this recent rise in inflation? What does it mean for the economy, as a whole, and for investment markets in particular? And how does this translate into our portfolios? Let’s explore.

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What is inflation?

At its most basic level, inflation is simply the change in prices of consumer goods and services. For example, a hamburger that cost $5 last year and now costs $5.50 has experienced a 10% rate of inflation. To measure price changes across the broader economy, many countries define their headline inflation indicator as the change in price of a basket of goods and services, typically called the Consumer Price Index (CPI). The all-inclusive CPI, however, can be dominated by price fluctuations in volatile sectors like energy, so a core CPI measure, which excludes food and energy, is also used to assess inflation in the other sectors.

While the CPI captures a broad basket of goods and services, we can experience inflation differently from others depending on the particular good or service, its availability, our personal incomes, and even geography. A case in point is housing and how it’s captured depending on the methodology¹. High-demand urban areas like New York and San Francisco (and Toronto and Vancouver in Canada) are often touted as places where the price of real estate has run amok, and where people with average incomes could not afford to live. However, most other locations in the US may only experience moderate changes in housing price, if at all.

Why is inflation important?

Consumers want the best deal they can get, so when prices change due to inflation, it can affect our spending behaviour. As such, why do the Federal Reserve and Bank of Canada not aim for zero or even negative inflation? Wouldn’t lower prices provide more purchasing power to consumers?

It’s because negative inflation or a deflationary environment may actually hinder growth. If consumers expect prices to fall in the future, they may delay spending now, which will slow the economy. This may lead to a vicious cycle where prices then fall further to attract buyers. So an expectation of future inflation can be healthy, since consumers will be more likely to make purchases now. Certainly if inflation spikes, there will likely be adverse impacts to consumption and hence the broader economy. The tumultuous period of the aforementioned 1970s and early 1980s is a major reason why central banks have targeted low inflation as part of their monetary policies.

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How does inflation impact investing?

We’ve all heard our parents and grandparents talk about how far a dollar went in their day. But it’s true—inflation erodes the value of money. What you could buy with $100 today is far less than what the same amount would get you 10, 20 or 30 years ago.

Hence, when we’re constructing our portfolios, and assessing expected returns and risks, the real return—the return one receives after subtracting the effect of inflation—is an important characteristic, especially if inflation is higher than expected. An average annual return of 10% may sound quite good for a moderate risk portfolio, but if inflation is running at 12%, then the real return is actually -2%. In other words, you may have made 10% on your investments, but your purchasing power has been reduced since prices have gone up by 12%! Your investments have not kept pace with inflation.

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What does current inflation look like?

Due to the size and influence of the US in the global economy, any hint of unusually high inflation in the US could be a sign that other countries may follow. But not every country or region will experience inflation at the same time or with a similar magnitude.

In Canada, for the month of August, the CPI posted a 4.1% gain, which is the highest yearly gain since 2003 (see chart below). Elsewhere around the world, inflation measures also hit levels not seen in many years. Europe saw inflation bump up to 3%², the highest since 2011, and the U.K. hit 3.2%³. The one notable outlier is Japan⁴, where prices have been decreasing since September 2020 (emblematic of its decades-long struggle with deflation).

From February 2020 to August 2021, Canadian CPI grew 2.5% on an annualized basis, which is in line with the five-year average at 2.1%. The US is in a similar position, where the most recent CPI increase came in at 5.3%, largely driven by energy (up 25%) and used car prices (up by almost 32%). Looking back to February 2020, the US CPI grew an annualized 3.6%, which is 1% higher than the five-year average to the end of August 2021, but not at levels to cause immediate concern.

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Can we expect transitory or persistent inflation?

The steep decline in economic activity during 2020 as a result of the pandemic put much of the world into a deflationary environment. That’s typical with any recession. Higher levels of unemployment and economic uncertainty often leads to a drop in consumption, and that lack of demand generally causes prices to fall. It’s easy to forget, but in May 2020, just a few months into the pandemic, the annual inflation rate for Canada was -0.4%. In other words, prices fell.

The opposite is true during an economic recovery and expansion. Employment recovers, consumer confidence improves, and people start to spend more readily. Businesses, on the other hand, can often be slower to transition. Having cut costs to be defensive in a downturn, they need to hire again and quickly resume production to accommodate the new demand. This takes time, however, and in the interim the increased demand for goods and services will outstrip supply. This may result in larger price increases, which translates into higher inflation.

The economic decline and subsequent recovery in 2020 happened extremely quickly, so the supply disruptions as a result have been exacerbated compared to what we would typically see. There is evidence of these dislocations in several areas of the market. Shipping container prices, lumber prices, used car prices, and chip shortages, to name a few, have all been prominently covered in the media.

If you’re a business owner in this environment, you recognize that excess demand for your products and services is a good problem to have. Those willing to find a way to get products to consumers will be rewarded. As this continues, supply will eventually meet demand leading to more competitive prices again. Inflation at that point would be expected to abate and normalize back to the long-term 2% target.

This is known as transitory inflation, which is caused by supply and demand imbalances and is normal during an economic recovery. Long-term inflation is known as persistent inflation, and is much more of a concern. In theory, persistent inflation would most likely occur as a result of continuing labour shortages. If employers can’t attract new employees to increase production, they offer higher wages. Higher wages put more dollars into the economy, which increases the price for goods. Employers raise wages again, which leads to a further increase in the price of goods. This can create an ongoing cycle of rising wages and rising prices, which results in—you guessed it—higher inflation.

The central banks are well aware of this potential price-wage spiral. It’s the reason they look to raise interest rates to cool off the economy when employment peaks. Policy makers learned the importance of a cooling-off period during “the great inflation,” which lasted from 1965 to 1980.

Worries over inflation today stem from the quick recovery we’ve just seen. Equity markets are roughly 30% above the highs of February 2020—uncomfortably quick by historical standards. There are also reports of frictions starting in the labour market, with anecdotes about businesses needing to offer sizable wage increases to attract or retain talent. What we don’t yet know is if the global economy is experiencing typical transitory inflation or if we’re much further along in the business cycle than we realize and potentially facing persistent inflation.

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How are the central banks managing inflation?

Since one of the key responsibilities of central banks is price stability, the regulation of inflation plays an important role in setting monetary policy. To achieve this, most central banks have adopted inflation targeting, whether that is a range like the Bank of Canada’s (BoC) 1% to 3% or an absolute value like the US Federal Reserve’s (Fed) target of 2%. Central banks didn’t always have a target inflation metric, but the introduction of a target in 2012⁵ for the Fed and 1991⁶ for the BoC has been effective at taming inflation and keeping prices relatively stable.

Central bank policies aimed at stabilizing inflation can also stall economic growth. On a fundamental level, this makes sense; raising the policy rate raises borrowing costs, which leads to business activity slowing, in turn causing general economic slowdown. 

Therefore it’s important for central banks to balance economic growth and the subsequent inflation that follows. Recognizing their outsized ability to slow the economy, central banks have generally taken a “wait and see” approach with fewer pre-emptive actions to curtail inflation. 

The most recent analysis of inflation from Canada, the U.S. and Europe suggests it might be time for central banks to act to curtail inflation. The pandemic initially led to a slowdown in inflation as economies were closed, but the speed at which economies have bounced back upon reopening has led to dislocations in the market. This has resulted in the inflation that we see today. Therefore, the central banks view the inflation as transitory in nature, and are expected to self-correct as pandemic-induced supply and labour constraints are resolved.

More recently, the Delta variant of the COVID-19 virus has caused some disruptions for inflation’s return to the 2% target. The US Federal Reserve (Fed) has recognized this risk, but believes that such disruptions will have a minor effect, and should be resolved by the end of 2022. The Fed forecasts a ‘slow return’ to 2% by 2024. The BoC and ECB (European Central Bank) have also recognized the additional risk from prolonged supply chain issues, but still see inflationary pressures easing before becoming a problem. 

Despite these risks, the economy has recovered significantly since the onset of the pandemic, leading the Fed and ECB to discuss tapering - that is, slowing down their quantitative easing programs. Quantitative easing refers to the process of central banks injecting liquidity into an economy by buying assets, like government bonds, during periods of financial crisis such as the beginning of the pandemic. The Fed expects to begin in December, but the ECB is still treading carefully for now and has only trimmed emergency supports. The BoC on the other hand initiated tapering in April 2021, and has indicated it will continue to do so as the recovery progresses.

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How are the ATBIM funds positioned against inflation?

When it comes to the long-term positioning of our funds, we need to be mindful that despite the potential threat of increased inflation, it’s probable higher inflation will be transitory, as anticipated by the central banks. We’ve built our portfolios to be resilient against inflation, and expect stable long-term performance of our funds whether higher inflation materializes or not. 

Here’s a look at each asset class within the portfolio:

Fixed income:

For bond investors, unexpected inflation means a heightened possibility of rising interest rates. Given the current low interest rate era, the funds have been positioned for the possibility of rising interest rates since 2012. It’s no secret that bonds struggle when rates increase, but higher-duration (longer-maturity) bonds tend to be most at risk. We have implemented measures to mitigate the potential impact of rising rates, inflation, and our current low-rate environment, in four ways. 

1. First, we moved towards a higher allocation of shorter-maturity bonds. While on average these bonds yield somewhat less than longer-maturity bonds (assuming an upward-sloping yield curve), they can be rolled over at higher rates more frequently should rates actually increase. They are also less sensitive to changes in interest rates when compared to longer-term bonds.
2. Second, to compensate investors for the lower-yielding, shorter-maturity bonds, a higher allocation is given to corporate bonds and mortgages. The additional yield coming from credit spreads will compensate investors whether or not higher rates or inflation materialize.
3. Third, we recognize we’re not the only ones searching for additional yield. Should markets decline, we can’t count on corporate bonds to offer the same level of liquidity they have in the past⁷. We will maintain flexibility through dedicated government bond holdings. 
4. Fourth, participation in buying riskier corporate bonds continues to entail an opportunistic approach. This is not new for ATBIM, having roots back to 2007 with the hiring of Canso as our credit sub-advisor. The quality of our bond holdings typically increases if we are not being compensated at a level commensurate with the risk taken. Conversely, when perceived value is apparent as it last was in March 2020, we’ll take advantage by purchasing discounted out-of-favour bonds.

Our fixed income component is designed to work well in a flat- or rising-rate environment, whether inflation increases or moderates, and add value when opportunity arises.This approach isn’t new for ATBIM; our portfolios, especially the fixed income component, have been positioned with the intention to withstand rising inflation rates for a decade.

Equities:

Historically, equities in aggregate have performed quite well through various inflationary environments. This makes sense because business owners can often pass along the price increases of supplies onto consumers. Consider businesses with strong competitive moats or pricing power, such as those selling necessities like groceries or utilities. 

One of the more important drivers of equity performance is economic growth. In our current environment, inflation in the US is roughly 5%⁸. Real GDP growth over the same time frame is 12.2%⁹. So we have higher-than-usual inflation, but we also have much higher economic growth than is usual. Equities tend to react more to growth than inflation. Rising inflation and slow growth are common indicators of a late stage business cycle when equities are more at risk of a correction.

Diversification:

The final consideration in defending a portfolio from inflation is global diversification. As stated in the section on the current environment, inflation is primarily showing up in the US and Canada with levels over 4% year over year. Inflation in European countries has started to increase but is holding to lower levels so far. In Asian countries, inflation is even lower, with Japan and China sitting at less than 1%. Global diversification reduces risk in a portfolio, and the localized impact of inflation on any individual country is a risk that can be mitigated.

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What are the benefits and drawbacks of real estate, inflation-linked bonds and commodities?

The following classes of securities are not significantly represented in the current portfolios managed by ATBIM, but are often considered when defending a portfolio against inflation. Here are our thoughts on why we don’t include them. 

Real estate:

Investments in real estate may have inflation-hedging benefits, as property values and rent (as income) tend to move with the economy and inflation. One can invest directly by purchasing buildings (less efficient due to its illiquid nature) or indirectly via investment vehicles such as REITs (real estate investment trusts). REITS, however, are a component of the stock market. ATBIM does invest in REITs as a component of equities both passively, and actively should valuations look attractive.

Inflation-linked bonds:

These bonds are commonly brought up as a way to hedge against inflation, but are more complex than most realize. Unlike regular bonds, the price of these bonds fluctuates based on expected and realized inflation. In a nutshell, investors need inflation higher than expected to benefit from holding these bonds. If inflation meets expectations, the investor receives the current yield on the bonds (expressed in real terms), and experiences a decline in value if inflation is lower than expected. Today, the current yield on these bonds is negative—not very compelling.  

Inflation-linked bonds excel if we see higher unexpected inflation over time, but fail to deliver beyond that scenario. Shorter-duration nominal corporate bonds and traditional equities also have a good chance of adding value in an unexpectedly higher-inflation environment, but would do well even if that’s not the case. For that reason, we believe inflation-linked bonds do not exhibit enough investment appeal at this time to be included in the portfolios.   

Commodities:

Commodities are often cited as a great inflation hedge, but excluding the 1970s—which saw extraordinary events from the end of Bretton Woods, and two significant oil supply shocks—commodities have not added any additional value over inflation. Since the 1990s, central banks globally have embraced price stability and inflation targeting. Commodity prices overall have fallen by about 50% in real terms as shown in the chart. This chart shows a simplistic timeframe, but it highlights that an investor needs to be directionally right with commodities, and also that commodities are highly cyclical and volatile. 

Closing comments

Besides stories about COVID-19 and its impact on the economy, the risk of persistent high inflation has been the topic du jour for the past few months, at least in our industry. While it’s easy to get caught up in the current news cycle, it’s clear why inflation has reared its ugly head and spurred a lot of talk. Central banks have been quite successful at taming inflation over the past three decades, so seeing levels of inflation not experienced in many years has made it more newsworthy than usual.

When assessing the impact of inflation on our portfolios, it’s important to take a step back and realize it’s just one of a multitude of factors that could influence the portfolios’ longer-term performance. A sustained period of rising prices should certainly not be ignored, but we believe and trust central banks will take action to curb inflation when the need arises. Policy makers have staked their reputation on being inflation fighters, which they’ll want to uphold.

In any event, we have strategically built our portfolios with a globally-diversified mix of stocks and bonds designed to be resilient in a variety of scenarios. Whether inflation is transitory or persistent, we believe our portfolios are well-positioned for the longer term.

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