Getting spooked by inflation? Here are four things every investor should know

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The return of inflation is now the scariest Halloween horror story on the market. But how afraid should investors be about the threat from rising prices?

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It depends who you ask. Central bankers remain remarkably unaffected. There is no movement in the bond market either. Many economists also emphasize that the spurt in inflation is only a passing phase in the post-lockdown recovery.

But there are notable exceptions. Take Alan Ruskin, a macro strategist at Deutsche Bank who published a report this week called A Hangover Like No Other.

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“We are now dealing with the threat of inflation,” he wrote. They are of the view that inflation will not peak before the middle of next year and could last much longer if central banks do not get out of their control.

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If so, and policy makers have to suddenly raise interest rates to rein in rising prices, then Bay Street and Wall Street will resonate with pain. Since the 1990s, investors have relied on “central bank puts”—the belief that central banks will always run to the stock market’s aid in times of crisis. (Compare this to a put option, which provides a floor to an individual stock price.)

If rising inflation forces policymakers to suddenly raise interest rates, their action will erode central bank confidence, regardless of the bone-breaking effect on stock prices. There can be chaos. “It is unclear whether investors are quite prepared for these results,” noted analysts at London-based money manager Man Group.

It’s scary stuff, to be sure. But before loading up on the inflation hedge, investors may want to keep the risk in perspective. Here are four things to remember:

It’s not your father’s cost

The Bank of Canada and the US Federal Reserve have acknowledged that what they initially described as a “momentary” bump in post-pandemic inflation has lasted longer than expected. However, this does not mean that we are going back to the 1970s.

At the time, annual inflation in Canada and the United States had risen to more than 12 percent. By comparison, today’s inflation is running below half that level – 4.4 percent in Canada and 5.4 percent in the US.

Most forecasters expect the price increase to moderate in the coming months. Capital Economics, for example, sees the Consumer Price Index (CPI) in the US to rise by about 3 percent in both 2022 and 2023. This would be higher than the 2-percent level that most central banks aim for in normal times. , but subdued compared to what we experienced half a century ago.

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the world has changed

There are many excellent reasons to dread the return of the 1970s, but they mostly have to do with widespread bell-bottoms and disco. When it comes to financial conditions, investors should avoid easy analogies between then and now.

At least three major shocks were needed in the 1970s to prop up inflation, Daniel Alpert, managing partner at investment bank Westwood Capital, said in a statement. Essay Last week. Setbacks included Richard Nixon’s decision to move America away from the gold standard in 1971, the oil crises in 1973 and 1979, and the Baby Boomers’ unprecedented boom in the workforce throughout the decade, which fueled increased consumer demand.

None of these conditions now apply. Yes, oil prices have risen in recent months, but their gains relative to pre-pandemic levels have hardly been recorded compared to the tenfold increase in the 1970s. Meanwhile, there is no monetary shock compared to the end of the gold standard and the work force aging and retiring, not expanding suddenly.

bond market okay thanks

The bond market provides a good guide to what smart money should expect from inflation in the coming years. This is a sign of concern but not a crisis.

For example, look at break-even rates. These are calculated by comparing inflation-protected government bonds in real, or post-inflation, versus how much regular government bonds pay in nominal or pre-inflation terms. The difference between these two yields reflects the market’s expectations of what inflation will be in the coming years.

Right now, break-even rates on the 10-year US Treasury stand at 2.54 per cent. This is higher than pre-pandemic levels, but not in line with central banks’ 2-percent target, especially since many of those institutions – notably the Federal Reserve – have reduced their tolerance to slightly higher than normal inflation. desire is indicated. economic recovery.

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humility is good

“The biggest error in analyzing the economic impact of a pandemic is trying to see the last 18 months as a normal cycle,” says Paul Donovan, chief economist at UBS Global Wealth Management. He has a point. Policy makers are faced with an extraordinarily difficult task of understanding the meaning of today’s readings.

Some inflation drivers — such as wage gains and house price increases — may be halted. Others, such as microchip shortages and a surge in freight demand, are likely to reduce bottlenecks at ports. But we’ve never tried to restart an advanced global economy after a major pandemic before, so no one knows.

What should investors take from all this? One conclusion is to be wary of anyone who claims to know what inflation will do next. New one Study Both consumers and experts have been poor inflation forecasters, especially over the past decade, as shown by the Federal Reserve Bank of Cleveland. For now, there’s good reason to be cautious, but not enough reason to radically reorganize your portfolio based on a horror story that may not come to pass.

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