Readers may be perplexed with the headline of this blog. ‘Transitory’ is the term being used by most central banks to describe the current hike in inflation we are observing across the world economy. The UK’s monetary policy committee (MPC) expects inflation to rise above its 2 percent target. Ben Broadbent, the Bank of England’s deputy governor stated, “I’m not convinced that the current inflation in retail goods prices should in and of itself mean higher inflation 18 to 24 months ahead, the horizon more relevant for monetary policy”. US inflation hit a 13 year high in June with the consumer price index hitting 5.4%, driven, amongst other items, by the rising costs of used cars.
What does the recent spike in inflation mean for markets? In theory, rising prices will put pressure on central banks to tighten monetary policy sooner than expected, which could in turn dampen a consumer led recovery. However, central banks seem reluctant at present to pull the trigger. They see the inflation as transitory and are also hesitant to get in the way of an economy which is still in the early stages of a recovery. Were inflation to be more persistent, it is likely that the central banks will start to reduce monetary stimulus sooner rather than later. The most obvious asset class to suffer in such an environment would be fixed income, i.e., bonds and gilts, but some sectors of the equity market may also be at risk. Companies which do not have pricing power and whose valuations are based on more distant cashflows (something which inflation may erode) may not be immune should inflation be persistently high. Conversely, companies that can pass the rising costs of production on to their customers and maintain sales should weather periods of inflation better.
The future is always uncertain and so we do not seek to predict the course of inflation. Instead, we remain on high alert to the risks that financial assets would face should inflation evolve from a transitory blip to something more permanent. As such we seek to hold assets in the portfolios which would be robust in either event.