Inflation Risks looms in the Post COVID-19 World

Summary

• Countries are re-opening now, investors prefer risk assets now and sovereign yields are on the rise of late.
• Commodity prices have picked up from the lows as there is some revival in demand albeit supply side constraints exist.
• As of now, there remains uncertainty over the demand and supply dynamics, which will make a case for inflation or deflation.

Dismantled supply chains, scattered labour force, deglobalisation, and most recently a pick-up in commodity prices augurs well for inflationary pressure in any economy.

But the factors that may contribute to inflation are not limited to the above only. Others include massive liquidity, ultra-low interest rates, potential demand outpacing supply, and the unknowns as well.

At the same time, a weaker demand outlook instigated by sluggish wage growth, unemployment, underemployment, reluctance to spend and distressed financial conditions of households – will likely create deflationary pressure.

On Friday, Australian Dollar clocked USD 0.70 against United States Dollar, touching new six month high. As a risk-on currency, it is indicating the pickup in commodity prices, substantial trade surplus amongst other things.

While the US 10-year bond yield has been rising over the past month, it was around 0.903% on Friday. A rising yield is also indicating a rotation in the markets towards risk assets. Coupon on the US 10-year bond is 0.625%.

Yet it is not just US long term rates that are rising, the UK 10-year gilt rallied to 0.358% on Friday from 0.272% a month ago. Likewise, the Swedish 10-year Government bond was at 0.054%, coming out of negative yields a month ago.

Similarly, Australian 10-year Government bond ended the week at 1.102% - after hitting low of 0.57% in March – this, in part due to relatively higher interest rate differentials, also explains why Australian Dollar has been strengthening over the recent past.

Stock markets are, indeed, among the leading indicators of the economy as they discount future while also taking cues from the past, which comes in the form of economic data. Since markets are rallying across the board, it appears that investors are expecting constructive economic conditions over the course of the future.

What makes a case for inflation?

Inflation may rise over the next one to three-year period, largely due to large scale policy expansion by the central bankers. Interest rates are at record low levels, which makes the case of refinancing by business and households.

As demand picks up in the economy, owing to a recovery in household conditions like employment, wage growth and de-stressed balance sheets – it will likely create inflationary pressures in the economy.

If we look at the commodity prices, they are returning back from the suppressed levels we saw over the recent past. A subtle rise in commodity prices is indicating that demand is coming back online among other things – should there be a second-wave of infection – the consequent effects could be adverse.

And wait, there is more – supply side disruptions stemming from the COVID-19 issues may induce producers to raise prices as factors of production are scattered and stabilising in an asynchronistic pattern – where businesses, countries are returning to normalcy in a staged manner at different time frames.

For instance, iron ore prices are rising, partially due to the inability of Brazilian supply to return to normal levels as pandemic has caused large scale disruption in the country, especially in the mining region.

But supply-side problems are not only arising out of COVID-19. Deglobalisation, protectionism and a recent inclination to manufacture domestically may cause stress in the supply chains as well, prompting suppliers to revisit costing of products.

Potential supply side shocks could be more than what are known presently as many small businesses that were supplying might have been forced to close doors due to coronavirus led economic shock.

So there is uncertainty over the demand and supply dynamics – and output is also restricted, stemming from dislocations in inputs – these factors make a floor for producers to raise prices.

Also, the world’s beloved reserve currency may lose its charm, owing to depleting interest rate and growth differentials relatively as well as rising deficits (fiscal and current account). Moreover, a lower USD could be inflationary for the world as well.

And what does not makes a case for inflation?

Deflationary case revolves around the assumption that shock to demand is severe, which would force the producers to lower the price instead of a hike. For instance, the recent crash in oil prices was largely attributed to a collapse in demand.

Shock to demand could be severe due to rising unemployment, sluggish wage growth, underemployment, thus a stressed household demand. When there is a lack of demand, producers tend to offer value-driven products, which means lower prices.

In the near term, the deflationary scenario could be expected as demand risks continue to loom. Companies are likely to offer heavy discounts to lure customers and demand, thereby hurting their margins.

COVID-19 led shutdowns have led to excess capacities in the economy, with demand expected to remain tepid over the near term – capacity will likely fall short once demand picks up. However, economies are re-opening now, which is making the demand to return to some extent.

Implications for your portfolio

It is observed that gold, commodity exporting nations, commodity producing stocks perform well in periods of inflation. On the other hand, one would like to hold sovereign debt and high quality bonds in the period of deflation.

Most of the times, inflation occurs as a result of rising demand for goods and services amid weaker supply that usually happens amid a recovery phase of the cycle, which induces central banks to hike the interest rates to maintain stable prices. Likewise, the economic inability to instigate demand revival results in economy to slow down and that would prompt central banks to keep the rates lower for longer.

Assuming that economy is recovering, investors are likely to hold cyclical asset classes that stand to benefit from the recovery in the economy.