Reflation is the expansion in the level of output of an economy, often fueled by government stimulus, causing upward pressure on prices. What does this mean for investors?
Current state of affairs: inflation is largely absent
Over the past few years, before the pandemic in 2020, job markets in many regions across the world had been the strongest for decades, yet inflation has remained elusive.
Why?
Globalisation Sourcing products at a lower price from anywhere in the world is much easier in a more globalised world.
Technology Technological developments have lowered the costs of delivering services.
Central Bank Policy For some time, central banks have been coordinated and succesful in their inflation targetting policies, causing an extended period of low and stable inflation in many economies.
What has this meant for investors?
Central banks keeping interest rates very low has prompted strong gains in bond markets and some parts of the global stock market.
We expect inflation to rise over the year, but at a moderate rate, though this will be heavily dependent on how we manage the pandemic and return to normality. According the the Office for Budget Responsibility the UK inflation rate of the Consumer Price Index is expected to be 0.8% throughout 2020, before rising to 1.2 percent in 2021, and 1.6 percent in 2022. This reflationary environment will be as a result of:
Economic Stimulus As part of their efforts to mitigate the economic damage caused by the lockdowns, central banks have been buying huge volumes of assets under their quantitative easing programmes, government spending has ballooned, and following the Democrat victory, we can expect more to come.
Scarcity post-Covid19 As economies begin their recovery from the pandemic, we may see inflation pick up in industries which were hurt more during the Covid pandemic, where there might be a shortage of supply causing consumers to place a premium on scarce products.
Savings rates Meanwhile, household savings rates spiked during the lockdowns. Consumers may well spend their excess savings once restrictions relax later in 2021.
Timothy Foster | Fidelity International Co-Investment Manager | Omnis Strategic Bond Fund
VIEW FROM THE MANAGER
I am optimistic that inflation will pick up in 2021 as a delayed response to the huge monetary and fiscal stimulus that has taken place in 2020, and as growth recovers from the Covid-19 crisis. I also expect monetary policy to stay very easy in all major economies. Although the US should recover more quickly than other regions, the recent change to the Fed’s approach (it plans to allow inflation to run above target for some time) is likely to limit any increases in real and nominal yields, particularly for bonds with shorter maturities.
The big worry for US inflation had been that rents (the largest part of the US inflation basket) would be very weak next year. However, the home-buying market has remained very strong (in contrast to the 2008 recession) and I expect this trend to support rents in 2021.
Inflation-linked bonds aren’t especially cheap, and although the fundamental outlook is positive and the asset class continues to see inflows, valuation is less compelling after a strong run in the second half of 2020. Consequently we’ve kept a small allocation to US inflation-linked bonds in the Fidelity Strategic Bond Fund. However, we favour corporate bonds, which are also supported by positive fundamentals and inflows, and should benefit from a reflationary environment in 2021.
OUR INVESTMENT CASE
In this moderately reflationary environment we favour equities over bonds.
We are cautious on potential returns for bonds. With yields already at record lows, new buyers of bonds receive little by way of income and the potential for further capital gains appears slim. As a result, we have an underweight allocation to bonds in discretionary portfolios.
We have an overweight position in equity markets. In particular we favour those sectors that benefit from a vaccine and a pick up in economic activity.These offer the best valuation opportunities.
