Why Inflation Could Rise Over the Long Term
- In developed markets, there is a serious debt problem, and inflation is one of the only "solutions" we see as likely to occur.
- We see a secular rise in global commodities prices – with some cyclical dips – as the middle class expands in emerging markets in the years ahead, consuming more commodities.
- Structuring portfolios in an attempt to guard against high inflation should be a central element of any investment strategy. The core asset, in our view, is developed market inflation-linked bonds (ILBs), such as Treasury Inflation-Protected Securities (TIPS) in the U.S.
Has the world become too comfortable with inflation, counting on little or no price pressures for the foreseeable future?
In the following interview, portfolio manager Mihir Worah looks at global inflation risks over the next three to five years and talks about preparing for the risks – and opportunities – investors may not be considering.
Q: What is the secular outlook for inflation?
Worah: We expect global inflation over the next three to five years – or even the next five to 10 years – to be higher than it has been over the last 20 years. While we do not expect double-digit inflation, we do see inflation gradually climbing higher than the close-to-2% core numbers that we have gotten used to in much of the developed world.
There are a number of reasons for this, but two are most critical. First, in developed markets, there is a serious debt problem, and it is going to be hard for developed countries to grow out of it. Inflation is one of the only "solutions" that we see as likely to occur.
Second, emerging markets for years have been a force of disinflation, exporting very low prices for goods and services, and we see that changing. Estimates vary, but the middle class in emerging markets could expand by about 2 billion people over the next two decades, and that means commodity-intensive uses could increase – as people move from mud to concrete, buy washing machines, cars and more. Thus, we see a secular rise in global commodities prices – with some cyclical dips – contributing to global inflation. A more indirect contributor to inflation could come in the form of emerging markets reaching a limit to the productivity “miracle” and that potentially translating to higher production costs and, ultimately, higher export prices.
Finally, for the U.S. in particular, over a secular horizon we expect the dollar to decline against currencies in the higher growth regions, and that would be inflationary.
Q: How does that outlook vary by region?
Worah: While we expect generally higher inflation globally, there is likely going to be a greater degree of differentiation than in the past.
Emerging markets, which are likely to experience relatively stronger economic growth, are also likely to see higher inflation for the reasons just outlined: wage and commodity-price pressures. Commodities are a large part of their consumption basket, and, thus, inflation in emerging markets is much more sensitive to commodity-price movements than in developed markets.
Turning to developed markets, we could see significant differentiation within Europe. To regain competitiveness – and assuming the euro prevails – we believe that either peripheral European countries need to experience substantial deflation, or core countries must experience significant inflation, or some combination of the two. So, for example, we could see a downward movement in prices in Greece, Spain and Ireland and an upward movement in Germany and France over a secular horizon.
In the U.S., we expect core inflation to gradually rise over the next few years, up from the 2% or so today.
Q: If unemployment remains elevated in the developed world, do you expect central banks to continue easing even if inflation increases? Could we see stagflation?
Worah: To answer the second question first, we do not expect ‘70s style aggressive inflation. But what we have discussed so far – our expectation for somewhat lower growth with somewhat higher inflation – certainly has a whiff of stagflation.
Regarding central banks, this question is the easiest to address in the U.S., where the Federal Reserve has an explicit dual mandate: jobs and inflation. The chairman of the Fed has already said that, in the current environment, bringing the unemployment rate down is more important than keeping the inflation rate tightly anchored at 2%.
We expect that this policy stance will be mirrored by central banks that do not have a dual mandate; i.e., getting the unemployment rate down and generating growth prospects will take precedence over a very tight adherence to 2% inflation.
So if central bankers err in the timing of when to reverse monetary easing, we believe it is more likely they will shift too late than too early.
Q: If the eurozone fragments, could that lead to global deflation?
Worah: Global deflation is certainly a tail risk that cannot be ignored in the event of a complete, disorderly fragmentation of the eurozone and a subsequent collapse in global demand. However, we believe policymakers will come forcefully to the rescue. We saw that in 2008.
Also, we think there are strategic buyers of commodities who would step in at lower prices. China and India, for example, are building strategic oil reserves that they could expand in the event of a severe decline in oil prices. So there is a floor under commodities prices, in our view: Prices could decline precipitously for a few months, but we think the emergence of "dip buyers" combined with forceful policy actions should truncate a sustained era of deflation.
To be sure, austerity measures in peripheral Europe ought to cause downward pressure on wages, and earlier we discussed how deflation could play a role in returning the periphery to competitiveness. But what we have seen over the last couple of years is that even with high unemployment rates and slack in those economies, wages are not falling substantially. This suggests there is an element of stickiness to nominal wages, and to inflation at low rates. To some extent, companies seem to find it easier to reduce their workforce than to cut salaries, and at a macro level we have not yet seen a deflationary trend in these countries.
Q: How should investors be thinking about and positioning for inflation in their portfolios?
Worah: Thinking about inflation and structuring portfolios in an attempt to guard against high inflation should be a central element of any investment strategy. Hedging inflation risk can take multiple forms, and there are multiple assets that serve as good inflation hedges.
The core asset, in our view, is developed market inflation-linked bonds (ILBs), such as Treasury Inflation-Protected Securities (TIPS) in the U.S. We believe these should be the bedrock of any inflation hedging strategy – “the money under the mattress,” with principal backed by the full faith and credit of the U.S. government. These bonds may offer more modest return potential, but if held to maturity, their real returns are known since the payments are explicitly linked to inflation.
Beyond a core allocation to ILBs, investors may wish to venture out into slightly more volatile assets in order to seek potentially higher returns; these include real assets such as commodities, as well as dividend-yielding equities and real estate investment trusts (REITs). And investors may consider ILBS from emerging market countries, such as Mexico and Brazil, that have strong fiscal balance sheets and yet whose bonds we believe offer the potential for relatively attractive after-inflation rates of return.
Past performance is not a guarantee or a reliable indicator of future results. Investing in the bond market is subject to certain risks including market, interest-rate, issuer, credit, and inflation risk. Investing in foreign denominated and/or domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Inflation-linked bonds (ILBs) issued by a government are fixed-income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the U.S. Government. Sovereign securities are generally backed by the issuing government, obligations of U.S. Government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the U.S. Government; portfolios that invest in such securities are not guaranteed and will fluctuate in value. Equities may decline in value due to both real and perceived general market, economic, and industry conditions. REITs are subject to risk, such as poor performance by the manager, adverse changes to tax laws or failure to qualify for tax-free pass-through of income. Commoditiescontain heightened risk including market, political, regulatory, and natural conditions, and may not be suitable for all investors. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. ©2012, PIMCO.
