Why inflation could corner central banks in 2018

by | Dec 29, 2017

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The 2018 outlook from Fidelity International’s Multi-Asset CIO James Bateman, who looks at what will happen when central banks step back in 2018 and why investors must stay mindful of inflation.

“What happens when central banks step back is the big question for 2018. There are some who believe that the impact will be limited, with investor demand sufficient to make up the shortfall. The risk is that investors panic, either because they fear interest rates are going higher than expected, or simply because central banks are no longer around to underpin risk assets. At the very least, the end of quantitative easing is likely to test the ‘buy-the-dip’ mentality – particularly in fixed income markets like US investment grade bonds.

“Are worries misplaced? Central banks could simply step back in, with Mario Draghi promising to do so if needed. This assumes, however, that monetary policy remains unconstrained by inflation, which has lain dormant since the financial crisis. Indeed, it’s only eighteen months since we saw peak deflation fears, with 10 year German yields reaching -0.3% and a third of all government bonds globally trading at negative yields.

 
 

“The potential for regime shift should not be dismissed lightly. Central banks have been accommodative for a very long time. Labour markets are now tight across almost every major economy, with the main exceptions concentrated in the eurozone. At some point, workers will feel secure in demanding wage increases. Wage inflation might have kicked in at higher rates of unemployment in the past, but that doesn’t mean it’s never coming back. When it does come through, it can accelerate quickly, and sharply reduce central banks’ room for manoeuvre.

“As well as upward pressures on inflation, some of the broad deflationary forces we have seen in recent years are disappearing. 2014’s 50% fall in the oil price, for example, could not be repeated without causing massive damage to the oil industry. More broadly, the deflation in consumer goods driven by the integration of China and other emerging economies is now largely over, with there being relatively little left to come from integrating other economies.

Structural deflationary risks are exaggerated

“I also think that some of the structural arguments for deflation are exaggerated. The internet is a good example of this, with people arguing that the ability to compare prices puts pressure on producers and forces margins down. While that can be true, the internet has also coincided with a period of low inflation globally, with its deflationary impact potentially exaggerated by circumstance. If we see producers facing rising cost pressures, then prices might not be as sticky as they have been in the past, with the internet making it very easy for producers to push prices up. And if all producers are facing cost pressures, either from higher wages or raw material costs, they will all have an incentive to push prices up. Price transparency might not always work in favour of the consumer.

 
 

“Inflation is a risk to my outlook, rather than a base case. But given the outsized impact it could have on markets, investors should consider having some inflation protection in their portfolios. Floating rate loans are a good option here, having delivered relatively muted capital gains over 2017 and offering a steady yield. Beyond inflation protection, I would maintain a positive stance on equities, though with an inclination to reduce that as the year wears on.”

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