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Government Stimulus and The Risk of Inflation

Updated: Jul 16, 2020

Unprecented government stimulus could lead to a rise in inflation— how do investors plan to hedge against it?

Late last week the Bank of England reported that the UK Consumer Price Index (CPI) — a measure which is frequently used to identify inflationary and deflationary periods — fell from 1.5 percent to 0.8 percent in April. As the health crisis leads to low consumer confidence and a drop in spending, many commentators forecast that deflation is set to stick around for some time to come. Others however are antithetal to such predictions, and instead predict that inflation will likely rise.

Coronavirus is deflationary

Over the last decade we have become so used to low levels of inflation that many economists are fixated on the dangers of deflation, or falling prices, which could arise out of the pandemic. So concerning is this scenario that Andrew Bailey, the Governor of the Bank of England, is not ruling out negative interest rates which would see a cut in the cost of borrowing to below zero.

The assumption that the pandemic will trigger deflation is born out of the notion that mass lay-offs and high levels of unemployment, as we are already witnessing across large parts of America, will eradicate a big chunk of consumer demand. Workers with reduced incomes will be forced to cut back on spending, leading to a fall in prices to counter a lack in demand. Post-pandemic consumer confidence may well take some time to bounce-back, exacerbating a lack in spending and pushing prices down further, leading to deflation.

Some analysts however, such as Ed Smith, Head of Asset Allocation Research at Rathbones, point out that the risk of inflation is a real possibility.

Coronavirus is inflationary

Although the Bank of England is predicting that inflation will drop close to zero over the coming year owing to a continued lack of demand for goods and services coupled with a drop in commodity prices, the necessary conditions required for a rise in inflation — mainly unprecedented levels of government spending — are currently being met; the Office for Budget Responsibility believes UK government borrowing will reach a peacetime record of £300 billion for this year.

Along with government borrowing, the case for inflation is also based on the premise that social distancing measures and continued lockdowns will deliver a nasty sucker punch to the supply of goods and services, rather than to demand as was the case in 2008 when consumers lost confidence in a faulty banking system. Take the airline and hospitality industries for instance. Once flights and restaurants resume normal services, capacity under social distancing measures, dictating that passengers and customer keep two meters apart, will naturally be reduced. In such a scenario prices are bound to rise. Those airlines and restaurants less financially prepared for the pandemic will sadly be forced to lay-off staff or worse, go bust, reducing supply even further, increasing prices even more and entering a spiral. Add to this unprecedented levels of government stimulus, the geopolitical risk of a Sino-American trade war and a possible reduction on the reliance of global supply chains especially in China, and one has the ideal ingredients for a significant increase in costs, and therefore in prices.

How could different investment assets be affected by a rise in inflation?

Owing to their negative linkage to interest rates and inflation, returns from fixed rate bonds are at risk of being detrimentally affected by a rise in inflation. Although interest rates could drop below zero, they will sure enough rise again with inflation. To off-set this, bond investors, and equity investors too, could tilt their portfolios towards inflation linked bonds indexes which offer greater returns when inflation rises — this is one of the few assets that provide a solid hedge against a rise in inflation.

In terms of equities, equity investors should be focusing on companies with strong pricing power: companies who have the ability to pass on rising costs to customers. Investors need to bear in mind a company’s liabilities too. As inflation rises, central banks will try and off-set its effects by pushing interest rates up which will badly effect companies whose cost of borrowing will go up. As such, equity investors should turn to cash compounding companies with quality sheets, strong profitability and a history of positive returns on invested capital.

British vulnerablity

As an open economy, Britain is particulary exposed to the pandemic.

Although much of our attention has turned away from Brexit, Britains exit from the European Union almost four years ago is another key variable when considering the likehood of a rise in inflation. The possibility of doing less trade with our biggest trading partner as a result of “no-deal” Brexit is not a good prospect — a crash would force new tarrifs on UK importers across a range of goods in January, and result in increased costs due to customs checks at the border. In such an enviroment, large government defict and borrowing become a far riskier enterprise.

The crash of 2008 was different in the sense that its causation was down to a faulty banking system which led to a strict policy of austerity. This time around though, a more relaxed attitude towards spending, coupled with unpredecented levels of government stimulus and faulty supply and demand dymanic may well lead to a rise in inflation.

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