Managing Inflation Risk With Financial Assets
Over the past decade, inflation has been driven down by falling commodity prices, low capacity utilization and high unemployment rates. The rebound in commodity prices and improving job markets will help push inflation higher in most developed countries, especially in the US and the UK. Eurozone inflation will rise, and there are upside risks in the medium term. Long-term inflation expectations have already been raised.
We have raised our inflation forecasts for the coming years based on a number of key factors.
The first source of inflation is the recent rise in commodity prices, particularly energy and industrial metals. Indeed, oil prices have risen from a $30 low to around $50 in recent weeks. Following the latest decision from OPEC (Organization of the Petroleum Exporting Countries) to cut production, we have raised our target range for end-2017 to $50-60. Industrial metals (copper, aluminium, zinc and iron ore) also witnessed a sharp rebound last year after a long period of falling prices.
The second key factor is Mr Trump’s election victory and the raft of policy measures expected over the coming months. Regarding economic growth, we expect a large infrastructure stimulus programme and selected tax cuts. This should push economic growth higher, mainly in the United States, but also in Europe and the UK. This will generate a further improvement in the employment market and should lead to an acceleration in wage growth and higher inflation. Given that some job markets are already facing tight conditions, the effects should be much more noticeable in the United States and the UK than in the Eurozone.
A more specific factor relates to the US and the likelihood that the new President could use barriers to trade and introduce tariffs on some imported goods. This would increase production costs for US companies and drive up the price of consumer goods. Whether companies pass on the increase in costs to final consumers will depend on pricing power and the extent of competition they are facing. A stronger dollar could limit these effects. We have not factored these into our inflation forecasts but there is a risk of higher inflation.
How to hedge against inflation
Investors who want to hedge against higher inflation - i.e. secure the purchasing power of their assets - have several options. Structured products (using inflation derivatives), Newcits funds and inflation-indexed bond funds (with active interest risk management) are the main examples.
Newcits funds allow fund managers to benefit from rising and falling asset prices, depending on the strategy. In this context, we favour so-called macro-economic strategies which can benefit from market trends in several asset classes such as commodities, currencies, interest rates, etc.
Inflation-indexed bond funds pay a fixed coupon that excludes inflation, and realized inflation is added after the period. This allows investors to hedge against inflation risk as the coupon payment is based on inflation at the end of the period. There is however an interest rate risk as the value of the bond falls when real rates (excluding inflation) rise. Fund managers can manage this risk by using derivatives.
Inflation risks are highest for the United States and the United Kingdom.
Medium-term inflation risks for the Eurozone should not be underestimated.
Risks to our base case
The main risk at this stage is a sharp fall-back in commodity prices or disappointments regarding US fiscal policy plans. This would reverse the dynamics of the past few months and reduce inflation expectations again. This would negatively affect the investment solutions mentioned above. An actively managed fund should limit such risk.