For much of the past decade economists and investors have debated whether inflation is dead, or merely sleeping. Within a year, it will be clear that it is very much alive and kicking.
Markets are not priced for this. At the moment, investors are focused on the very near-term effects of Covid-19, which will undoubtedly be deflationary. In the coming months, headline rates of inflation will plummet, not least because the dramatic fall in oil prices will drag global indices of consumer prices lower. Annual inflation rates will, for a few months, turn negative.
But within a year, we will be looking at a very different picture.
For a start, oil prices will pick back up. Russia, Saudi Arabia and the US — the three largest producers of oil — are caught in a game of chicken. They have so far failed to come up with a solution that sufficiently addresses the current oversupply in the market.
But none can sustain Brent crude below $40 a barrel for long. Saudi Arabia needs its oil revenue to finance government spending. There are also fewer projects in North America that are viable with oil below $50, so supply will naturally contract, pushing prices higher in the longer term.
Moreover, the shifting inflationary outlook is not solely dependent on the trajectory for energy prices. The increase in inflation will be broader across a range of goods and services.
When stay-at-home restrictions are removed, demand will roar back. Families will flock to restaurants, shops, shows, and mini-breaks — anything but remaining in the homes they have been confined in.
Households will, in many cases, have built up savings to fund such a binge. In Europe, this is thanks in large part to the generosity of governments’ employment subsidies which should mean that the rise in unemployment is modest.
In the US, the fiscal stimulus is less about making sure people keep their job and more about boosting the social safety net. Average weekly unemployment benefits have been increased from roughly $385 per week on average to $985. Our judgment is that a lot of people who receive this benefit will actually be better off while out of work.
The recovery in demand will be much swifter than the recovery in supply. It will take some time for dislocations in global supply chains to be resolved and shop shelves to be restocked.
Service providers such as restaurants will be keen to capitalise on the return of their customers and recoup the losses of the spring and early summer. Food and theatre prices will rise.
The ability of some companies to raise their prices will be enhanced if some of their competitors have not made it through the shutdown. Households may have a smaller range of restaurants and shops to choose from.
A rise in the broad price level, alongside some recovery in oil prices, will see overall inflation jump. This might prove temporary if the short-term supply constraints ease and governments withdraw their generous fiscal injections in a timely manner. However, there is also a risk that policymakers leave the stimulus in place for too long.
Policymakers have demonstrated in recent years a clear tendency to err on the side of delivering too much rather than too little. And populations will not tolerate talk of a new wave of austerity so soon after the last. It is possible that the monetary and fiscal taps remain turned on for longer than necessary, allowing medium-term inflationary pressures to build.
The most obvious investment opportunity is inflation-protected bonds. The most recent time the global economy stuttered and oil crashed was 2015. The benchmark basket of UK inflation-linked bonds returned minus 1 per cent that year. But in 2016 the same bonds returned more than 25 per cent.
It is tempting to think that a whiff of inflation will spell trouble for standard government bonds given current low yields. Price rises erode the real value of future coupons and thus the value of nominal bonds. However, the primary role of central banks in this crisis is to help governments fund their debt cheaply. Given that the size of the fiscal expansion is unknown, central banks are increasingly shifting to maintaining low yields as their stated objective.
By the time we expect inflation to return, most developed world central banks will be operating yield curve control. The Japanese and Australians are already there. Effectively, the US Federal Reserve is too.
This is significant — the 1940s showed that a determined central bank can hold down bond yields even when the nominal economy is expanding rapidly. But even if government bonds do not suffer significant losses, a more inflationary environment will favour a portfolio more heavily tilted to stocks over bonds.
Karen Ward is chief market strategist for Emea at JPMorgan Asset Management