What was the best-performing asset class in 2020? If you think “tech stocks” or “bitcoin”, think again. Instead, as the Bridgewater hedge fund recently wrote to its clients, “among the more interesting and least recognised outcomes” of 2020 was that US inflation-linked bonds beat other assets by delivering a 35 per cent return, on a risk-adjusted basis, as investors hedged against inflation risks.
This is a notable straw in the wind. It might seem bizarre that anyone should fret about American inflation now. Data on Wednesday showed that annual US consumer price inflation was a measly 1.4 per cent in December. Wage growth is also weak, unemployment high and economic activity dragged down by the pandemic. Even if growth resumes in 2021, recent decades suggest that the twin forces of globalisation and digitisation should keep prices in check.
Most notably, the internet has unleashed new global forms of price competition for goods, services and labour. It may well continue to do so, given that Covid-19 has accelerated the digital shift. Today, almost everyone has become adept at online shopping, while companies have discovered many employees can work remotely. So the competitive pressures that keep a lid on inflation seem to be rife.
However, the reason why investors have rushed to hedge against inflation is due to a concern that inflation might prove to be a “black swan” event, with a low-probability but high-impact risk.
In recent years, most investment portfolios have been constructed on the assumption that interest rates and inflation will stay low indefinitely. This means that if anything rocks this consensus, there will be a nasty market whiplash. Indeed, right now, there are at least three factors that should give investors pause for thought.
The first is short-term reflation risk. Although economic growth is currently weak due to the pandemic, the incoming administration of president-elect Joe Biden seems poised to unleash more fiscal stimulus. If this hits the economy as the Covid-19 vaccine becomes widely available, there might be a surge in economic activity later this year.
If rising demand then collides with supply-side bottlenecks — which is likely because the lockdown has destroyed capacity in some sectors — prices could jump in some areas, especially leisure and services. Esther George, the head of the Kansas Federal Reserve warned as much this week.
Other Fed officials, such Lael Brainard, argue that any such price jumps will be temporary. Maybe. But the second issue for investors to consider is that the structural factors that kept inflation low in recent decades — particularly globalisation and digitisation — may shift. As Charles Goodhart and Manoj Pradhan argue in a new book, demographic pressures in places such as China could create labour shortages and thus wage growth. Increased trade protectionism might raise service and goods prices, too. Globalisation’s recent past may not be a good guide to its future.
The third and perhaps most important issue is the stance of the US Federal Reserve. Another factor that kept US inflation expectations low in recent years was the sunny assumption that the Fed’s 2 per cent inflation target left it committed to act preemptively if inflationary pressures grew. But that assumption increasingly seems wrong.
One reason is that Fed officials now say 2 per cent is not a ceiling but an average long-term target, meaning they may let inflation rise above 2 per cent for periods. Another is that political and economic pressures could make it increasingly hard for the Fed to act pre-emptively, since any rise in interest rates also increases the cost of servicing the government’s ever-swelling debts.
“In the old regime the Fed was trying to arrive on time. Now they are saying we are not going to arrive on time but instead . . . be late by design,” Bill Dudley, former head of the New York Fed told me. “When interest rates start going up, the debt-service problem will finally come evident . . . You have to worry about the pressure on the Fed to not tighten as much as they need to.”
In the long term, all this means that the chances of a future inflationary shock are rising too, as Mr Dudley and some other Fed officials recognise. “We are in this La La Land right now where the Fed’s quantitative easing is providing support for financial markets [and] markets are just not focused on the end of QE,” Mr Dudley warns. “But at some point the Fed will have to hint that it is moving into another regime.”
When that occurs, “there could be a taper tantrum”, adds Mr Dudley, referring to the 2013 market swings that occurred when Ben Bernanke, then Fed chair, gave the mildest of hints that the central bank might cut, or taper, its QE programme. Indeed, there is every chance that the next tantrum will be orders of magnitude worse, given that the Fed has so explicitly encouraged investors to bet on rates staying so low for at least two more years (which I consider to have been a mistake).
Thankfully, that risk probably lies in the future. The Fed’s tone is still dovish. But what is here now is a shift in inflation probabilities from “very low” to “not so low”. Investors are thus correct to hedge their bets, however gloomy the news about the pandemic. After all, something else we learnt in 2020 is that the unthinkable sometimes does become unexpectedly real.