Inflation: What investors need to know

The US just printed a 7% y-o-y increase in inflation. Europe is hardly lagging though, with German inflation rising to 5.7% in December and overall Euro area inflation at 5%. What do investors really need to understand to ensure their portfolios are well protected?

• Inflation is already extremely high
• Interest rates of -50bps in the Euro area are not consistent with 5% inflation, GDP/unemployment close to pre-Covid levels, a recovering economy/pandemic and close to maximum fiscal and monetary support
• Yes, inflation is peaking but the question investors should be seeking an answer to is: ‘What is the likely inflation level in the coming year or two and specifically, is it likely to be much lower than 2%?’ Inflation impacts market yields and interest rates which have a direct impact on bond portfolios and equity valuations

So, is there anything we can sensibly say about inflation in the coming year? There is a reasonable expectation that goods inflation, which is pushing up current inflation, will abate as demand rebalances towards services and supply chains respond. That is the good news. European inflation is coming down from 5%. However, companies are likely to pass on at least some of their current higher input costs to consumers, households have seen their real wages sink this year and higher energy costs are likely to galvanize their desire for higher wages in 2022/2023. What this means is inflation, though falling from its highs, may well be stickier and higher than the optimists hope for, especially as inflation expectations are picking up.

The US Fed is beginning tapering and the market now expects four interest rate increases this year. With the German 10 Year government bond yielding 0%, yields are likely to trend higher. With the ECB almost certainly under pressure to bring policy rates back from -0.5% to 0% and inflation expectation rising, bond holders are likely to continue to see volatility and relatively sparse returns.

Where can bond holders access reasonable returns? One area of the bond market that has top decile yields and half the duration of the overall bond market (thereby reducing any likely volatility) is financial sub-ordinated bonds. As central banks have not included these bonds in their huge QE programs, yield has been left on the table for investors.

The equity market is slightly better poised for higher yields, though the longest duration equities are beginning to experience more volatility and poorer performance eg some tech companies. The financial equity sector is one of the few sectors that benefits from higher yields. The European bank sector has 40% upside to where it was as recently as 2018, as it recovers from the Covid-19 recession.