Why sensitivity to inflation risk comes at a cost

Chief economist believes that, aside from short-term pressures, long-term inflation is likely to remain subdued

Why sensitivity to inflation risk comes at a cost

Heightened sensitivity to inflation risk comes at a cost to your portfolio, according to a chief economist.

Todd Mattina, Chief Economist and Senior Vice-President, Mackenzie Investments, has released a new report titled Why Financial Markets Shouldn’t Fear Inflation, in which he outlines why he believes inflation is more a tail risk for investors, albeit one with large potential consequences should it happen.

He told WP that warnings of upcoming inflation risks after recent elections in the U.S. are "eerily similar" to previous false alarms in the past decade, from the aftermath of the Great Financial Crisis (GFC) to analysis of Donald Trump's surprise win in 2016.

Given the potential impact of it happening, Mattina is pleased markets and investors are worried about the prospect. Mackenzie’s view, however, is that, aside from some short-lived inflationary pressures in 2021, expected inflation over the next five to 10 years is likely to stay more subdued and closer to 2% targets.

As an investor, the scenario begs the question: how much should you hedge this risk? Mattina said the important thing to recognize is that there has already been a significant move in asset prices to factor in this expected move in inflation. What you do next depends on whether you feel the risk of even greater inflation is more than what the markets have already priced?

He said: “If you look at breakeven inflation rates over the next one-year period in the U.S., markets' breakeven rates are about 3%. That's quite a significant number. If you look at five- and 10-year horizons, breakeven inflation rates are more like 2%. Markets appear to have already priced in this risk of higher short-term inflationary pressures and more moderate and subdued inflation in the long term.

“If you were an investor who is concerned about inflation sensitivity, and of having greater inflation sensitivity in your portfolio, [my point would be that] inflation sensitivity is like insurance. Just like insurance, you generally have to pay in order to have that extra sensitivity.

“And if you look at the inflation-sensitive asset classes out there, like inflation-linked bonds, commodities and so on, generally the expected return on those asset classes is a lot lower than your traditional 60-40 portfolio mix.”

Short-term potential inflation pressures are in sight. A strong surge in cash account balances is possible given how much the private sector has saved during the lockdown, while excess savings during the pandemic [stand at] $1.5 trillion in the U.S. Both could finance a surge in spending once vaccines have been successfully rolled out.

Mattina added President Joe Biden’s proposed $1.9 trillion stimulus package, on top of the almost $900 billion package in December, as a further example of a dramatic increase in money supply.

However, he doesn’t see long-term inflation moving dramatically higher becasue of the scarring from the pandemic recession and long-term unemployment that’s moved higher. It will take time for that excess slack to work itself out of the system, he said, while record levels of corporate debt as a share of GDP could also be a headwind for capital expenditure.

He explained: “The other thing is a return to secular stagnation in the long run, which are all of the forces we were thinking about a lot before the pandemic, like demographic aging, a glut of global savings, very low average productivity rates. They will reassert themselves after the downturn, keeping downward pressure on inflation and long-term rates.”