Wellian Weekly 22.03.2021

Where next for inflation?

Since the start of the year, global bond markets have been getting nervous. Bond yields have been steadily rising upwards (and bond prices have been falling) indicating a fixed income sell-off is underway. And in the last few weeks, that nervousness turned into a rout, as the yield on United States 10-year treasuries jumped from 1.48% to 1.62% on fears of significantly higher levels of inflation. Here in the UK, 10-year gilts also spiked sharply higher too.

Fixed income investments deliver, as their name implies, a fixed amount of income. Compared to shareholder dividends, it is an income that is more stable, more resilient, and more predictable – but also fixed - the price that you pay for a bond or gilt at the point of purchase determines the return that you get thereafter. And that fixed return means that periods of inflation can sharply erode the real after-inflation income from holding bonds and gilts, making them less attractive to investors and what is driving the sell-off. In fact, both fixed-income and equity markets have been twitchy about inflation since December.

With household cash balances, the Covid-19 pandemic has had sharply different outcomes for many people. While the media is full of stories of people on furlough, and small business owners unable to open for business – think shops, pubs, restaurants and so on, many other people have continued to work and find themselves building up significant cash reserves with little opportunity to spend that money.

Here in the UK, household cash balances rose sharply during 2020, increasing by another £21bn during December. That’s on top of some fairly hefty debt repayment, with household net debt falling by £16.6bn, a lot of it coming from outstanding credit card and mortgage balances.

The story is similar in the United States. In December, US household wealth hit a record $123.5trn, and again, credit card debt fell significantly, reducing by $149bn during 2020. Put another way, when shops, pubs, and restaurants do eventually reopen, and it once again becomes possible to book holidays and visit car showrooms, an awful lot of people are going to find themselves with an awful lot of cash to spend.

Now on top of all that cash, there are also the economic stimulus measures that governments around the world are launching. Here in the UK, the latest Covid-19 support measures that chancellor Rishi Sunak announced in the recent budget have seen 2021’s projected levels of government borrowing leap to £355bn – a level that is unprecedented in peacetime. Furlough payments, help for the self-employed, cash grants to shops and hospitality businesses, various business rates holidays, and a lower rate of VAT for hospitality businesses have all been introduced.

Over in the United States, President Biden’s $1.9trn stimulus package is just as generous. Europe, too, is getting in on the act. Governments everywhere are spending, trying to kick-start pandemic-ravaged economies.

Quite simply, it all adds up to a giant tsunami of money, heading straight for the economies of the countries in question. So it’s not difficult to see why we expect to see higher inflation ahead. But the question will be for how long it will last. There will certainly be an immediate boom in spending on leisure activities and prices will be put up initially to reflect that demand, but this would be expected to normalise over time.

If inflation does indeed ratchet sharply upwards, expect bond and gilt yields to rise even higher until yields once again offer realistic real after-inflation returns. And with bonds being less attractive to investors, this could see money flow into the stock market instead, helping drive up share prices. And unlike fixed-income assets, shares also offer returns that have a degree of inflation-protection, further adding to their appeal. What is clear, it’s going to be another an interesting summer for investors.

 

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