What a high inflation new normal means for investors

The author is Chief Market Strategist for Europe, Middle East and Africa at JP Morgan Asset Management.

Inflationary panic is subsiding. Energy prices have stabilized and pandemic-related supply disruptions have eased. These factors alone should mean that inflation in the West will retreat from the spectacular double-digit rates we have recently experienced.

Central banks seem increasingly confident that they have regained control. Bond and stock markets are breathing a sigh of relief together.

As inflation falls from double digits, investors are looking to the question of where they will eventually settle. Will we revert to the stubbornly low inflation that has dominated for much of the last two decades, or will we persist at higher levels? In my view, 3% will be the new 2%. This has big implications for investors.

Higher and more volatile commodity price inflation is part of the story. One of the salient features of the low-inflation era was that the basket of non-energy commodities that the British consumer bought in 1990 was noticeably cheaper 30 years later. We cannot see history repeating itself.

Commodity prices could be exposed to commodity price inflation in the future, much the same as we have seen this year. Following Russia’s all-out invasion of Ukraine, the West lost a major supplier of many commodities.

A multi-year adjustment period impacts costs when migrating to alternative sources. Small producers in volatile regions of the world and reliance on renewable energy, which is subject to the vagaries of weather, lead to supply shortages and rising prices.

Moreover, sourcing of goods is no longer governed by lowest cost. Supplying critical inputs and managing the broader production chain is now very important for both businesses and governments. This may include onshoring or reshoring to countries with high labor costs.

A central bank might argue that if inflation of goods is persistently high, it simply needs to lower service sector inflation. While correct in theory, the political reality is less clear. A complete reversal of the experience of the last 30 years, and Western service sector workers will have to accept wage increases that are lower than global commodity price increases. Instead, we expect the central bank to accept a new slightly higher inflation rate.

Ultimately, I think this upward shift will not only be accepted, but welcomed. This is because a 3% inflation target, other things being equal, raises the average nominal interest rate by 1 percentage point.

That would make it less likely to hit the zero bound, the level at which interest rates can no longer be cut to stimulate economic activity, and force central banks to resort to unconventional policy tools such as quantitative easing. less likely to be lost. It is now abundantly clear, in my opinion, that quantitative easing will not replace conventional monetary policy. It entangles central banks with governments in ways that potentially jeopardize their independence, or at least perceptions of their ability to act independently.

Central banks are likely to reject the idea that inflation targets should be raised until the latest high inflation has passed.

Fixed income investors would do well to abandon the idea of ​​a long-term neutral nominal interest rate of 3%. We need to demand higher yields than the average of the last 20 years and a risk premium to recognize even more volatility.

The implications for equity investors are less clear. Because profits grow at a slightly higher rate, but profits are discounted when interest rates rise. Companies that have operated in revenue-struggling regions in the face of emerging market competition may benefit the most. European companies come to mind. A higher and steeper yield curve should benefit the global financial industry, but it will be a headwind for technology companies, for example. As a result, global value is favored over growth stocks.

Finally, investors need assets that protect against occasional high inflation. Unfortunately, neither bonds nor equities are helping, as has been all too well demonstrated this year. The best options here are private infrastructure, real estate and timber, which have a direct source of income due to inflation.

Investors are warned. Inflation has awakened like his teenager in a bad mood.