Episode 14: Inflation – Too hot? Too cold? Or, just right?

What is inflation and why are we seeing an increase to inflation expectations right now?

Wesley Blight [0:52] Inflation is when prices rise. So, I think a good example of inflation is last year – when people were stuck at home. They were looking for something to do and one of the things that popped up in their minds was, hey, I can do some home renovation projects.

So, there are lots of people across the country looking to do more home renovation projects and because of that, the demand for building materials went up. So, maybe using timber as an example, people were looking to do renovations to their outdoor areas, wanting to build the deck. Demand was high, but because more and more people were looking to do that, it was tough to get supply. So, the combination of rising demand and falling supply drove the price of timber higher and higher. That to me is a fantastic example of what inflation is.

And then why we're seeing a rise in inflation expectations is that last year, in February, March, April, during the depths of the crisis, consumer prices fell materially. And inflation is typically measured in rolling 12-month periods. So because prices had fallen so sharply and have since recovered, the base effect of low prices at the start of that 12-month calculation is starting to show up in inflation expectations moving materially higher from where they have been over the past 12 months.

The second factor is government spending. So there has been, all across the developed world, there's been a significant amount of spending to help consumers move through the pandemic with a similar level of income or a high level of income compared to what they otherwise would have had if they weren't able to go to work and continue doing their jobs.

Since the end of, well I guess, since the late part of 2020 and through the first part of 2021, we've seen additional stimulus coming from the U.S. government, and that they've had two major fiscal packages with lots of additional spending, kind of flooding consumers income and helping businesses move through rolling lock downs and move through this difficult environment. And because there's so much money coming into the system, people will look to be spending it somewhere. And that's going to keep that demand that I talked about earlier, higher.

Looking through all of that, I think that in our view is the reason why inflation expectations are so much stronger right now than they have been over the last couple of years.

Is inflation a good thing? A bad thing? What does this mean for the broader economy and investors?

Wesley Blight [3:40] That's a great question. So generally, a low level of inflation is a good thing. It means there's economic growth, it means that the economy is being well supported, and it's healthy.

Where it becomes bad is when inflation gets to be so high that the value of your money starts to deteriorate. And that it costs more and more money on a continual basis to be able to go out and buy the goods and services that you've been able to purchase in the past and your income level can't keep up with the price increases.

And what that typically does is it forces central banks to step in, to raise interest rates to try and slow an overheating economy. That does make borrowing costs higher. So, it costs more money to maintain your current living standards. So, when inflation starts to rise too high, that's generally a bad thing.

Central Banks typically around the world will target about a 2% inflation rate and that's generally seen as good and healthy.

What do we think the path for inflation looks like going forward then?

Wesley Blight [4:44] So I think with the price fall that we saw in the depths of the [COVID-19] crisis – the first wave back in February, March, April – prices fell dramatically and the way inflation gets measured, most often, is year-over-year inflation. So because we're now getting to a year on from when the prices fell so significantly last year during the first wave, inflation expectations have been pulled forward in the sense that people are expecting inflation to be, year over year, to be quite high. And we're starting to see that in some of the economic data that is being released more recently.

So, we think that inflation is going to move above the 2% target for a period of time, and then slowly migrate back towards what we think is a long-term sustainable level of inflation around 2%. I think this is a healthy thing. It is something to be cognisant of that we don't think that inflation is going to move sustainably higher than the long-run central bank target. But we will see it spike temporarily as a partial result of the base effect from prices having fallen last year.

Central bank policy has been integral to the global recovery and the U.S. Federal Reserve watches inflation very closely. How does this recent inflation activity impact policymaker actions?

Wesley Blight [6:14] Central banks are likely to look through the recent inflation impact.

And the reason for that is they recognize that it's temporary in nature, that the base effect that I described earlier, where the year-over-year, inflation is going to move materially higher because of the price decline that we'd experienced last year at this time.

[In the] middle of March, the U.S. Federal Reserve came out and talked about not reacting to inflation expectations but reacting to actual inflation. And actual inflation increases haven't happened yet. So yes, the investors around the world and capital markets are starting to price in higher inflation. But that is going to be, in our view, a temporary impact, and not something that the central banks around the world will react to.

They will keep their policy stimulus very high. So, they'll keep interest rates very low, we believe for the next 12 months, as these inflation expectations are going to not be found to be as sustainable as perhaps realized inflation was back in the late 70s, early 80s.

How has this impacted our strategy, or have we made any changes?

Wesley Blight [7:28] So we have made changes. We've made changes tactically within our portfolios to reduce duration. By lowering duration, we have stepped in and looked to cushion the impact of rising bond yields. So typically, when inflation expectations start to move up, bond yields also move up. And as a result of an expectation that inflation views for investors around the world were starting to creep up, we reduced our interest rate exposure from a bond perspective, allowing us to preserve capital when bond yields were rising.

Then at the same time, because we don't think that inflation expectations that are currently priced into the market are sustainable, we have gradually reduced some of that short duration exposure that we had first put into our portfolios back in January. To preserve capital, we've protected value as rates were rising. And now that we're kind of getting up to where we don't think bond yields will move materially higher from where they are today and inflation expectations that are currently quite strong, are unlikely to be realized on a sustainable basis, we've unwound a little bit of that short duration position. That has an impact on our portfolios from a tactical perspective.

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