Over the past several months, investors watched as markets shifted their primary focus from COVID-19 to rising inflation. For a large part of 2021, central banks referred to transitory inflation—higher rates that would fade as economies reopened and people resumed more normal lives. Things changed when US Federal Reserve Chairman, Jerome Powell, said: “It is probably a good time to retire that word (transitory)....” With that statement, it became clear that high inflation would likely run longer than originally forecast.
While mild inflation is generally good for the economy—as people can more easily plan their spending—high and rising inflation affects purchasing power, is unstable and unpredictable. Mr. Powell’s change of tone could have significant implications for that central bank’s next moves. For instance, the US Federal Reserve might move faster than expected to taper the liquidity it has been providing to markets. In addition, the pace of interest rate increases might also be faster and settle at a higher-than-anticipated rate.
Canada is very likely to adopt a similar path. While the Bank of Canada has already announced tapering measures and its intention to raise interest rates in 2022, the Bank will also have to watch how monetary policies unfold south of the border. If Canada happens to be more aggressive than the United States, our dollar could appreciate significantly and that would hurt exports. If Canada’s monetary policy is too dovish, inflation would join household debt and high real estate prices on the list of headwinds facing the domestic economy.
Central banks will also have to look at what’s driving inflation. Sluggish labour supplies, microchip shortages and supply chain disruption have been the main reasons behind the supply side’s inability to meet the demand side of the economic equation. Some of these problems might be reduced as vaccines continue to prove effective against different COVID-19 variants. The ability to go to work consistently could potentially significantly reduce inflation pressures.
From a portfolio construction perspective, inflation is a serious threat for more risk-averse investors as fixed income assets typically represent a significant portion of their portfolio. Such investors have valid concerns about the ability of that asset class to deliver income that can keep pace with inflation. What’s more, higher interest rates
would negatively impact the prices of some, but not all, fixed income securities.
We encourage investors to realize that not all fixed income assets are created equal and that a diversified, actively managed fixed income portfolio can help address those realities. Alternatively, good quality, growing dividend-paying stocks can typically help sustain investors’ purchasing power. With that in mind, it’s true that equity markets have never been a long quiet river. We think volatility is likely to linger as valuations remain high and world economies try to find an equilibrium in this environment.
Working with clients, we know some are looking beyond traditional asset classes as a means of maintaining purchasing power. Private investments in real assets (real estate, infrastructure, agriculture, timberland) are considered worthy hedges against inflation. Conversely, it should be noted that these kinds of investments are less liquid.
As pundits currently forecast the cloud of higher inflation to remain through the first half of 2022, take time to discuss concerns and options with your advisor and/or portfolio manager. Talk about the asset allocation and expected returns for your portfolio as the information will be key to planning for the years ahead.
NOTES:
“Fed's Powell floats dropping "transitory" label for inflation,” Breaking News, Reuters, November 30, 2021, https://www.reuters.com/article/usa-fed-instant-idUSKBN2IF1S0.