Rising inflation in the medium term is core to our investment views, but we believe this will have very different effects than in the past.
The “new nominal” is not simply about our expectation for a higher inflation regime in the next five years. It means stronger growth in the near term, and eventually higher inflation – without the typical rise in nominal bond yields. As a result, we see very different market implications than in the past. Previous episodes of rising inflation were costly for investors, leading to higher interest rates that pressured valuations across many asset classes via rising discount rates. Yet the policy revolution means any rise in inflation from today’s levels will likely be better for risk assets than in past episodes.
3 forces at play
Forward-looking estimates may not come to pass. Sources: BlackRock Investment Institute and the Federal Reserve with data from Refinitiv Datastream, November 2020. Notes: The chart shows market pricing of expected average inflation over the coming five-year period. We show it using the five-year/five-year inflation swap which is a measure of market expectation of inflation over five years, starting in five years’ time. In the chart, the line is shifted forward five years. The orange and green dots show our current estimate of average U.S. CPI and euro area inflation for the same five-year period of 2025-2030.Rising production costs
Production costs could rise on the rewiring of global supply chains and rising bargaining power of domestic workers as industries are re- or near-shored.New frameworks
Central banks are fundamentally changing their policy frameworks with the intent of running inflation above their targets.Political pressures
Central banks have signaled they will be more willing to let economies run hot with above-target inflation by changing their policy frameworks to make up for prior inflation undershoots. At the same time, the fiscal-monetary policy revolution – a necessary response to the Covid-19 shock – risks greater political constraints on central banks’ ability to lean against inflation. We see central banks likely curbing nominal yield rises to prevent an unwanted tightening of financial conditions.
We see other reasons for higher inflation, as detailed in Preparing for a higher inflation regime. Production costs are set to rise on the rewiring of global supply chains, while we see scope for corporates to exert their pricing power to protect profit margins. Corporate cost cutting may mitigate inflationary pressures in the near term. But even the moderately higher inflation in our base case – around 2.5-3% annually – would surprise markets after a decade of undershoots. See the Under-appreciated inflation risks chart.
Developed market government bonds in portfolios are challenged; with yields near effective lower bounds and central banks limiting yield rises even as growth picks up, we believe they will be less effective as portfolio diversifiers. Real yields look to be headed lower – one reason why we favor inflation-linked securities on a strategic basis.
Importantly, we believe this new nominal of constrained nominal bond yields will support risk assets. As a result, we are tactically more pro-risk and maintain a higher strategic allocation to equities than if higher inflation were to have its typical impact on nominal yields.