Inflation, a transitory phenomenon that lastsinformation provided by TRIBUNE LIBRE•11/22/2021 at 1:50 PM

Jonathan Baltora, Head of Sovereign, Inflation and FX at AXA IM. (photo credit: DR)

By Jonathan Baltora, Head of Sovereign, Inflation and FX at AXA IM

The combined effect of rising consumer demand, shortages of raw materials and ongoing disruptions affecting supply chains, inflation currently remains abnormally high.

We can however think that this situation is only temporary and should tend to normalize in the months to come. With an increase of 0.9% in October and 6.2% over the last 12 months, US inflation has reached a 30-year high.

In the euro zone, while annual inflation reached its highest level in 13 years at 4.1% in October 2021, the European Central Bank indicated that this surge was largely due to one-off factors and that price growth is expected to slow in mid-2022.

According to our estimates, it is now likely that US inflation will remain above 4% before falling at the end of the first quarter of 2022, while in the euro zone inflation should remain above 2.5% through the end of Q2 2022, before slowing down.

However, even when the price increases start to subside, they should remain relatively high compared to historical levels. This opinion is shared by the Organization for Economic Co-operation and Development (OECD), which has indicated that it expects prices to rise faster than before the pandemic in all G20 countries for at least the next two years.

Risks concerning the inflation scenario

Experience proves that inflation can surprise. By way of illustration, the market consensus was expecting an increase in inflation of around 1.3% in the Euro Zone in January for the year 2021, it will ultimately be above 4%. While the transitory nature of high inflation remains our central scenario, it is nevertheless important to monitor the risks. We see three sources of medium-term risk.

The phenomenon of globalization of world trade has been a major element in controlling costs for businesses. China's entry into the WTO coincided with a significant slowdown in inflation in developed economies. The transition from the Chinese export model to a domestic consumption model constitutes a risk for global inflation. China's role as factory of the world could shrink, which could have a significant impact on prices.

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We are also seeing a radical change in the relationship of states to public deficits, with central banks financing the rise in budget deficits almost without limit. Austerity in the euro zone is probably one of the reasons why the bloc's economic growth has been disappointing over the past ten years. The primary balances (deficit excluding interest charges on the debt) were close to 0%, whereas they were structurally negative in the United States. In fact, growth and inflation in the United States were higher than in the euro zone. The virtuous concept of budgetary austerity has given way to a global “whatever it takes” that could sustainably support household and business demand and thus push prices up.

Finally, the ecological transition also presents challenges. The raw materials used to manufacture batteries, solar panels and other wind turbines are highly sought after. Gas prices are soaring and the same is true for the price of a tonne of CO2 in the European Union, which has seen its price multiplied by 10 since 2017. It is a safe bet that these costs will be re-invoiced to the consumers.

Monetary policy and investment strategy

While there are many reasons to believe that the current inflation shock will be transitory, it must be recognized that this term has become more difficult to define in as inflation continued to surprise on the upside.

This situation paves the way for the normalization of central bank monetary policies. The Federal Reserve has, as expected, announced the gradual reduction of its asset purchases at its November meeting, with immediate effect, while the Federal Reserve Committee responsible for setting interest rates now considers a first hike as early as 2022. For its part, the Bank of England announced at its November meeting that it could, in the event that the economy evolves in line with current forecasts, proceed over the next few months to an increase in its interest rates.

In the euro zone, it seems that quantitative easing has become a constant of monetary policy as long as inflation remains relatively low. However, this constitutes another risk insofar as a more durable inflation would call this policy into question. Since the beginning of 2021, the inflationary shock has been considerable and has greatly exceeded the predictions of economists. Although we are convinced of the transitory nature of inflation, this year has shown that it can surprise on the upside without warning. For the time being, maintaining a level of inflation protection in investment portfolios may seem appropriate, even in view of the imminent normalization of monetary policies.

We favor inflation-linked bonds with short maturities in our portfolios. These appear to be relatively insensitive to fluctuations in interest rates and their indexation can make it possible to take advantage of high inflation. While taking into consideration the potential risks it entails, this strategy is, in our opinion, appropriate for dealing with the energy crisis while allowing the normalization of monetary policies to be negotiated.