NN IP: High inflation could be a major disrupter for financial markets

NN IP: High inflation could be a major disrupter for financial markets

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Marco Willner - NN Investment Partners.jpg

Low inflation has been a cornerstone of the financial world since before the turn of the millennium. Globalization has helped keep a lid on labour costs and import prices. It is precisely these factors that, accoriding to Marco Willner, Head of Investment Strategy at NN Investment Partners, could send inflation on an upward path should the process of globalization reverse itself. Central banks will have to be willing to take timely action to avoid a highly disruptive scenario for equity as well as bond markets.

 

The downward trend in inflation has been a key narrative for financial markets for the past three decades. Core inflation in the US, as measured by the personal consumption expenditure price index, spiked as high as 10% in the mid-1970s and the early 1980s. Since then, there has been a steady decline, a process set in motion by then-Fed Chairman Paul Volcker, who hiked the federal funds rate to as much as 19% in 1981.

These monetary policies ushered in the “Great Moderation”, a period of low price volatility and stable growth that lasted until the global financial crisis of 2008. Core inflation remained below 2% for most of the next 11 years, and since the outbreak of the Covid-19 virus it has dropped even further to around 1% currently.

Globalization has made low inflation possible
The Great Moderation was made possible to a great extent by globalization. Products produced in Asia were cheaper than those made in Europe and the US, where import prices declined as a result. Competition on labour and goods markets heated up and prices stayed low. Low inflation has meanwhile become a game-changer for debt sustainability. The Fed and the ECB can now keep interest rates near zero because inflation rates are low. This means, though, that if inflation accelerates, they will be forced to hike rates. Otherwise, we run the risk of high inflation.

The high-inflation scenario is a story of whether central banks will fail at the moment of truth – the moment when inflation rates start moving up. Will they have the resolve to raise interest rates if and when inflation increases? We are likely to see a number of inflationary forces in the coming decade arising from deglobalization and decreasing competition on the goods market.

If deglobalization takes hold, much production could return to higher-wage countries, work that new technology will not be able to absorb entirely. Increasingly restrictive immigration policies will also play a big role. All the factors that were positive in the globalization scenario might become the triggers for a high-inflation scenario going forward.

A high-inflation scenario would disrupt markets
What would be the impact? It could be the most disruptive scenario for bonds and equities. Bond yields would jump, and for equities, debt financing would become more difficult for companies, which would hit equity prices. Whether economic growth would still be positive in a high-inflation world is questionable. Low inflation was probably the strongest narrative over the past few decades for investors, and while the exact dynamics are hard to anticipate, such a shift in the inflation paradigm would probably create a very volatile market environment. Inflation might help governments reduce their real debt levels in the longer term, but the change from low to high inflation could be counterproductive for them too in the short term.

This inflation paradigm shift is just one of the plausible stories about the future, rather than a forecast. We need to think about the potential impact of such changes on financial markets. That is why we look ahead in terms of scenarios, unknowns, and triggers of potential changes. Such assessments are particularly crucial at a time when the Covid-19 virus has turned the global economy and financial markets upside down.