The risks that attend the recovery

Karl Otto Pöhl, a former head of Germany’s Bundesbank, once observed that “inflation is like toothpaste. Once it's out, you can hardly get it back in again.” Today’s central bankers will be hoping he is wrong. Excluding food and energy, US prices rose 3.8% in the 12 months ending in May, the highest inflation reading in years. Yet Federal Reserve officials have been near unanimous in their assertions that this year’s spike in prices is “transitory.” Along with central bankers in other developed economies, they argue that the recent data reflects pent-up demand and supply bottlenecks caused by the pandemic.

Transitory or not?

It’s a crucial question for investors. If inflation remains high for a sustained period of time, central bankers may scale back economic support measures sooner than markets currently anticipate. We don’t think interest rates will rise much over the coming years. However, even a modest rise could be unsettling in the short term.

A US unemployment rate of 5.5% suggests that the world’s largest economy should have enough labour market slack to keep inflationary pressures at bay. And yet there have been clear signs of upward pressure on wages, which may prove to be more enduring. This could reflect pandemic-related bottlenecks in the labour market. Employees may be postponing their return to work due to health concerns or childcare issues, for example, while generous unemployment benefits may be more tempting than some low-paying jobs. The result is that companies are having to pay up to lure staff back to work. These pressures may ease. But, as with toothpaste, it is unlikely that pay rises can be rolled back.

Prices jump: biggest increase since 1982

US consumer price index for urban consumers: all items excluding food and energy - monthly

^{Source: US Bureau of Labour Statistics}

Markets remain sanguine

Investors have generally accepted the central banks’ argument that we are seeing a temporary inflation spike. The market’s longer-term expectations for inflation are higher than they were immediately before the pandemic, but remain anchored at reasonable levels. This allowed global equities to rise another 8% in the second quarter, as measured by the MSCI World Index. Bond markets have also been resilient, recovering some of the losses they experienced in the first quarter.

While markets may be correct in looking through the near-term inflationary pressure, there is a risk that they are underestimating the longer-term risks. With strong growth set to continue this year and next, economic capacity could well become tighter in 2022, resulting in more sustained price increases.

History suggests that a modest degree of inflation is no bad thing for equity markets. Schroders’ research shows that equities outperformed inflation 90% of the time when inflation has been low (below 3% on average) and rising. But when inflation is above 3% and rising, equities become a less reliable investment, as the chart below shows.

Inflation and equity returns

% of rolling 12-month periods when US equity returns exceeded inflation rate, 1973 to 2020

^{Source: Schroders}

As ever, there will be many other factors that determine equity returns – and not just inflation. Planned fiscal spending will continue to drive the economic outlook, even if monetary policy becomes slightly less friendly. Climate change is another factor that we expect to have a growing impact. 

Climate stays on investors’ agenda

The latest sign of this has come in the form of legal and shareholder challenges to “Big Oil”. Shell was ordered by a Dutch court to accelerate its emissions reduction plans, while investors backed a board overhaul at Exxon to help the US energy giant develop a “credible strategy to create value in a decarbonizing world.” The investors behind the Exxon campaign were clear that this was a financial issue, pointing to the chronic underperformance of the company’s stock.

Climate action is not all bad news for more traditional industries. In fact, it is giving a new lease of life to some of the worst emissions offenders of the past. While Tesla has fallen out of favour this year, other carmakers have performed strongly as investors realise that electric vehicles could be a major driver of profit growth. It’s been a similar story with miners; copper, nickel and other metals are essential to the energy transition, providing a huge demand boost for companies that extract these commodities.

Ultimately, climate change will have very different impacts on different industries. However, it is very clear that investors are attaching greater importance to climate-related risks and opportunities. This will have a significant bearing on the relative performance of companies, sectors and markets in coming years.

Avoiding another taper tantrum

At some point, the Fed and other central banks will need to signal an end to their ongoing bond buying programme and start the process of raising interest rates. “Real” bond yields – that is, after inflation – stand at low or even negative rates, a situation that might unwind at some stage, presaging a sharp rise in nominal bond yields. The Fed’s attempts to unwind the stimulus measures put in place after the 2008 financial crisis – in particular the "taper tantrum" of 2013 – show that this can be a difficult process for markets. Officials will be keen to avoid a repeat of this volatility, which can have damaging economic consequences.

On balance, we think the Fed will slow its bond purchases this year and start to raise interest rates next year. Irrespective of the exact timing, high debt levels mean that interest rates will probably have to rise slowly and remain at relatively low levels.