Is inflation coming back and what should you do about it?
If you remember the 1970s, you will remember inflation, which struck fear into investors, economists, politicians and ordinary people alike. In 1980, price growth in the US topped out at a thumping 12.5%. The Federal Reserve funds rate hit an incredible 18%.
Mortgage rates hit almost 20%.
That’s right, 20%.
We live in a very different world today, when the Fed is targeting short-term rates of between zero and 0.25%.
US consumer price inflation stood at just 0.4% in the year to February.
The inflationary beast has been locked up for decades, but analysts fear this is about to change.
Should we be scared?
Hype and hyperinflation
When inflation lets rip, it can wreck civilisations. Germany is haunted by the hyperinflation of the early 1920s, when people took notes to the shops in wheelbarrows and 4.2 trillion German marks bought one US dollar.
Nobody is expecting a similar bout of hyperinflation but even relatively modest price growth could hurt investors.
Naturally, the pandemic is to blame. Or rather, our response to it. The world's fiscal and monetary policy makers have flooded the world with trillions of dollars, to prevent a global market meltdown and economic collapse.
It worked, but at a price.
Are we over-stimulated?
Last year, US stimulus totalled $3 trillion. In December, Congress approved a further $900 billion of relief, while new President Joe Biden pushed through a $1.9 trillion stimulus package which includes a one-off payment of $1,400 to most Americans.
Total support now exceeds a quarter of GDP, which is unprecedented.
The big fear is that when lockdowns end, the money could flood into asset prices and the wider economy. Especially when people start spending cash reserves built up in lockdown. US consumers are sitting on an estimated $1.5 trillion cash pile.
Worst, capacity has been reduced as companies mothball operations or collapse, so more money could be chasing fewer goods and services.
That's a recipe for inflation.
Spring is in the air
The Fed is forecasting GDP growth of a thumping 6.5% this year, up from the 4.2% it predicted in December.
The big danger is that the economy overheats and forces central bankers to hike interest rates faster and further than they would like.
In a world drowning in debt, that could prove expensive.
The last thing governments want is higher interest rates, as this will increase the cost of servicing pandemic debts.
So what would it mean for your portfolio?
The case against cash
Inflation would spell yet more bad news for cash. Getting a near-zero return on your savings is bad enough when inflation is low, but would be hellish if it shot past 5%.
While savings rates would also rise there is likely to be a lag, as the Fed isn't pricing in its first rate hike until 2024.
You don't want to hold much cash in these circumstances.
Bad news for bonds, too
Bond investors may also suffer. Bonds pay a fixed rate of interest, which is less attractive when rates are rising.
If you hold a 10-year bond yielding 0.75% when you can get 3% on cash, you won't be happy.
Especially if inflation is 5%, as the real value of your money is rapidly eroding.
As a result, bond investors are demanding higher rewards for lending out their money.
In May last year, 10-year US Treasury yields fell to just 0.51%. They recently hit 1.71%, having more than tripled in less than a year.
When bond yields rise, prices fall. The single worst performing investment fund across the entire UK market is Vanguard U.K. Long Duration Gilt Index (GB00B4M89245). It is down a whopping 11.9% year-to-date.
Bond investors don't expect that sort of loss.
Investors who still want some bond exposure might prefer strategic bond funds, which can shift between different types of bond according to market conditions.
Index-linked bonds will also look more attractive.
Suggested bond funds.
• iShares Global Government Bond UCITS ETF (IGLO) tracks government bonds from G7 countries Canada, France, Germany, Italy, Japan, United Kingdom and the US.
• BMO Global Strategic Bond Fund ETF (ZGSB) invests in global fixed income securities including US investment grade corporate bonds, global high-yield bonds, and emerging market debt.
• iShares $ High Yield Corp Bond UCITS ETF (IHYA) invests in global high-yielding corporate bonds. • iShares Global Inflation Linked Govt Bond UCITS ETF (IGIL) targets global inflation-linked government bonds.
Shares may also struggle
Stock markets can withstand inflation better than cash or bonds, as share price growth and dividends help generate a real return.
However, rising inflation makes consumers feel poorer by reducing their purchasing power, which will hit business revenues and profits, and ultimately, share prices.
Growth stocks such as US tech titans Amazon and Tesla have flown in recent years, as investors bet they will make massive profits at some future point.
However, if inflation lets rip the value of those potential returns will be reduced in real terms.
Many investors have been piling into value stocks instead, which offer slow but steady growth and dividends today, rather than tomorrow.
Suggested growth and value ETFs.
• Investors seeking growth might consider Vanguard FTSE Developed Markets ETF (VEA), iShares MSCI China ETF (MCHI), and US tech tracker Invesco EQQQ Nasdaq-100 UCITS ETF (EQQQ).
• For value investors, iShares Edge MSCI USA Value Factor UCITS ETF (IUVL) tracks US value stocks, SPDR MSCI World Value UCITS ETF (WVAL) targets large and mid-cap securities across 23 developed markets, or iShares US Financial Services ETF (IYF), which should help play the rebound in banks.
Gold may not glitter.
Gold is a traditional inflation hedge, but may struggle this time around. The precious metal does not pay interest, and the opportunity cost of holding it in your portfolio is greater when inflation and interest rates rise.
The gold price has now fallen more than 15% after hitting its all-time high of $2,068 last August.
• iShares Physical Gold ETC (SGLN) and Invesco Physical Gold ETF (SGLD) track the gold price. Alternatively, invest in the share prices of gold mining companies through the Van Eck Vectors Gold Miners ETF (GDX) or for smaller, riskier companies, Van Eck Vectors Junior Gold Miners ETF (GDXJ).
There are two potential winners from inflation. Cryptocurrencies and commodities.
Bitcoin but may benefit because its total supply is limited by computer logarithm, whereas central bankers can print as much “fiat” money as they like, reducing its value.
It is also a hedge against political instability and social disruption, which could come in the wake of inflation.
The downside is that like gold, Bitcoin doesn't pay dividends or interest.
Commodities tend to benefit from rising inflation because the prices of raw materials such as oil, gas, copper, iron ore and wheat typically rise along with everything else.
The copper price has just hit a 10-year high of more than $9,000, due to rising demand and investors betting on the recovery.
Hence all the talk about a commodity supercycle.
• You can track commodity sectors such as energy, agriculture, industrial metals, precious metals and livestock through the L&G All Commodities UCITS ETF (BCOM), WisdomTree Enhanced Commodity UCITS ETF (WCOG) or the iShares Diversified Commodity Swap UCITS ETF (ICOM).
New world, old rules
Inflation is not a done deal. Fears of a third wave of coronavirus in Europe could postpone the recovery. As ever, it pays to have a diversified portfolio and think long term, so you are ready for whatever happens. Maybe check out some commodity stocks, too.
Harvey Jones has been a UK financial journalist for more than 30 years, writing regularly for a host of UK titles including The Times, Sunday Times, The Independent and Financial Times. He is currently the personal finance editor of the Daily Express and Sunday Express, and writes regularly for The Observer and Guardian Unlimited, Motley Fool and Reader’s Digest.
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