HQ TrustOctober 27 2021

Inflation as an overarching risk for financial markets

3 mins read

Written by Dr Michael Heise, Chief Economist

By gearing their policies towards low-interest rates on government bonds and favorable financing conditions for businesses and households, central banks have made markets resilient to external shocks. Their ability to do so will diminish in the wake of higher inflation in the coming months.

Financial markets seem to know only one direction since the lows in the Corona crisis in the spring of 2020. The S&P 500 has increased around 90% since March of last year, while the EuroStoxx 50 has gained as much as 60%. Corporate bond markets, private debt and equity markets and real estate have also risen significantly. Negative news regarding e.g. repeated outbursts of the pandemic or increasing production bottlenecks, have not derailed the markets in their recovery. For investors, the last year and a half have brought exceptional returns. However, there is now growing concern that prices have reached such a lofty level that significant corrections have to be expected. Whether this will happen depends above all on what can be expected from the major central banks. Their accommodative policies have kept interest rates and bond yields extremely low and have thereby supported the high valuations of equities or risky corporate bonds. To put it differently, stocks may look expensive by historical standards, as price-to-earnings ratios are clearly above long-term averages, but they do not look overpriced at all when comparing them to the minimal yields of government bonds. And what is true for equity also holds for more risky corporate assets or real estate.

The linchpin for the possible path of monetary policy is the likely development of inflation. Stronger and more persistent inflationary trends would force monetary policy to reduce the level of accommodation and would diminish the room for maneuver needed to shield financial markets from negative developments. Central banks are rather optimistic about the inflation outlook. The current inflationary tendencies are seen as temporary since base effects are coming to an end and commodity price inflation and supply bottlenecks will disappear at some point in time. If this view holds true and inflation rates fall back significantly in 2022, then the stance of monetary policy will not be altered much and remain quite expansionary.

However, the view that inflation will be very subdued after the spike in 2021 is likely to be put to a test as supply bottlenecks prove to be longer-lasting and the already visible upward pressure on wages becomes stronger.  The situation is not like the extreme scenarios of price-wage spirals in the 1970s, but some wage acceleration is almost certain, as there is a shortage of labor in many sectors of the developed economies and employees are demanding compensation for the loss of purchasing power that has already occurred. In view of high job vacancies, these demands are likely to be met.   

As we are likely to enter a world with higher, one may say normalized inflation rates, investors should brace for higher volatility as upcoming risks like developments in China or conceivable new waves of the pandemic will not be cushioned by monetary policies in the way we have become used to. The markets’ vulnerability to negative developments is likely to increase.  But this does not imply a trend reversal on stock markets or for other risk assets. For a bear market to develop one would have to see a surge of inflation outside of the energy and commodities sectors that would force the central banks to push the brakes hard by ending asset purchases and raising short term rates rather quickly. This is a risk scenario with quite a low probability.  

Three points can be offered as a conclusion. First, in view of the increased inflation expectations, substantial funds will continue to be channeled towards investments that offer a certain hedge regarding price level rises. Such assets include equities and other corporate shareholdings and real estate. Their long-term return prospects are much more favorable than those for fixed-income securities in a situation with higher inflation rates. The “TINA” investment motive still holds: “there is no alternative.”

Second, with less monetary support and a gradual normalization of policies, valuations should fluctuate more strongly than so far in the post-Covid recovery. Monetary policy will no longer be able to insulate the financial markets from emerging risks as effectively as it did in the past quarters when inflation was hardly an issue. Investors’ watch lists should therefore include not only conceivable exogenous risks but above all developments in inflation, which could significantly restrict the room for maneuver of monetary policy. Leading indicators will include commodity markets, wage negotiations and corporate price expectations.

Thirdly, a market crash that abruptly ends the financial upswing and initiates a trend reversal is not likely at present. It would probably require a fairly massive turnaround in monetary policy, which is not on the horizon in the current situation and would require inflation to skyrocket.

What seems rather certain however is that the speed of the recovery will slow down with less monetary accommodation and the phasing out of large fiscal programmes. Return expectations for coming quarters will have to be scaled down after the boom since early 2020. But even with significantly weaker upward momentum and stronger ups and downs on the stock markets, there are opportunities for long-term investors.