Our often turbulent financial markets have taken a breather in the recent year. Global stock markets have grown by 2.1% to the time of writing, with the exception of India, where the markets have taken a tumble. European markets have jumped by 4.5% while the Nikkei in Japan has grown by 5.4% this year. The yield on 10-year Treasury debt has also dropped by more than half a per cent, or 37 basis points, to 2.54%.
After spending the first two months of this year arguing about currency wars and trade wars, investors have instead put their attention on inflation and what the Federal Reserve will do. Stock markets are becoming increasingly starved of liquidity, reflecting the current bond markets. However, the global economy is generally sound, fueled by both lower interest rates and the tax cuts that were passed in the US.
The Fed has clearly been implementing a tightening cycle, and expects the rate of inflation to rise above its two per cent target range over the next two years. However, this will not be a cause for concern, considering that the labour market is tight and most companies have already raised wages in response to it. The recent recession in Europe and the global slowdown, fuelled by trade concerns between the US and China, are also behind a downturn in global capital spending. As such, inflation appears to be slowing, with this move coming after so many years of disinflation.
Will inflation make a rapid return?
Most markets will not be lulled into complacency, however. The two biggest threats for the global economy and the stock markets are that it could run into a recession, meaning that the demand for goods will fall, which will impact demand for the goods that companies produce, and the second risk, relates to the expectation that global inflation will accelerate, which could force central banks to increase interest rates even more. The US government has been forecasting that inflation will hit 3.5% this year. According to experts at analysts at Societe Generale, this is because of tax cuts and wage increases. The investment bank claims that such a surge in inflation would be enough to force the Fed to increase interest rates more than four times this year. This would be a response to inflation risk, and would drive central banks away from rates and money supply, which might severely dampen investment.
So how should you play inflation?
Financial markets have only become more unpredictable over the past year, so choosing the right time to invest can be difficult. Therefore we asked Philip Miller, global head of real asset at BlackRock, where he believes the market will be heading, and in which sectors he thinks are best positioned to profit.
“Inflationary risk might not have been the main concern last year, but these events could cause the market to shift,” says Miller. “The equity markets have already started to temper inflation expectations with a shift in dollar rates. Whether this keeps inflation risks from emerging, we just have to wait and see.”
Miller is optimistic, however, when it comes to government bonds and their rising yields. The asset manager cites five factors for the expected rise in inflation:
With the passage of the Republican tax cut and deregulation, the tax refunds have given companies the cash they need to increase spending, which is driving job creation and wages. This phenomenon will mean that Treasury yields will rise faster than expected, particularly in the US, but in Europe and Japan they are also predicted to rise significantly.
A rise in US inflation could accelerate the US Federal Reserve’s rate increases. Meanwhile, inflation in China will rise as the domestic economy expands, which will mean that higher inflation will also be driven in the country’s trading partners.
The UK government wants to reduce its budget deficit, which makes up almost a third of the country’s total GDP, so it is critical that it boosts its international competitiveness. This will require some increased spending, especially on education and healthcare, which is rising in both countries.
With equity markets both in the US and Europe moving higher, there is a risk that investors will be discouraged from investing in those markets, despite the positive economic outlook. Fortunately, however, Miller believes that investors need not worry.
“Stock markets are going to be very good investments through these events,” he says. “We’re well positioned as a managed fund to deliver this in the UK and Europe.
“So if your money is moving in the direction of returns, there will be few risks associated with choosing a managed fund such as ours.”