Everyone’s Sure Inflation Is Going To Spike. What If Everyone’s Wrong?

Everyone’s Sure Inflation Is Going To Spike. What If Everyone’s Wrong?
Andrew Rummer

almost 3 years ago3 mins

Mentioned in story

What’s going on here?

Economists are ratcheting their forecasts for inflation ever higher, investors are nearly unanimous it’s about to shoot up, and CEOs can’t stop talking about the damage it could do. But they couldn’t all be wrong – could they?

What does this mean?

Cast your mind back to the start of the coronavirus outbreak last year, and you’ll probably remember how quick economists were to cut their estimates for inflation in 2021. But things have changed since then: those economists have pushed their estimates up by a full percentage point – 1.6% to 2.6% – since last summer.

Economists’ median forecast for 2021 consumer price index in US (Source: Bloomberg, Bianco Research)
Economists’ median forecast for 2021 consumer price index in US (Source: Bloomberg, Bianco Research)

Fund managers agree: a net 93% of those surveyed by Bank of America last month said they were anticipating higher inflation in the next 12 months. That tallies with our own Casual Investor Survey, in which a net 81% of you said you’re expecting inflation to rise. It’s in line with the world’s top CEOs too: mentions of the word “inflation” on post-earnings conference calls are up 300% from this time last year.

CEO mentions of “inflation” (Source: Bank of America, Bloomberg)
CEO mentions of “inflation” (Source: Bank of America, Bloomberg)

Why should I care?

Here’s the thing: it’s actually pretty rare to see such an overwhelming consensus in markets. But that doesn’t mean the consensus is right.

Ever since the 2008 financial crisis, after all, investors have been betting that the Federal Reserve would raise interest rates, pushing up bond yields and bringing down bond prices. But that’s barely happened: tepid inflation has forced the central bank to keep rates close to zero for years at a stretch. Just look at Fed funds futures: a measure of where investors think Fed interest rates will move. The dashed lines show investors’ expectations of a rise in interest rates, but the bold line shows the reality.

Source: Deutsche Bank
Source: Deutsche Bank

The current pro-inflation consensus, meanwhile, has driven bond prices down from the record highs reached in the teeth of the pandemic last year. That’s pushed smaller investors away from the bond market in favor of stocks. In fact, they poured about $20 billion more into stock market funds than into bond funds in March – the biggest gap since 2016.

Source: Investment Company Institute, Bloomberg
Source: Investment Company Institute, Bloomberg

So the consensus has well and truly spoken, but there is the odd dissenting voice out there. Asset manager Guggenheim, for one, pointed out on Monday that inflation should actually drop back to normal in 2022, thanks to smoother supply chains and the high bar set by 2021. Bond-focused investment manager Pimco, meanwhile, recently called the spiking inflation data a “headfake”, and predicted that inflation will actually fail to meet central bank targets in the next couple of years. And if the firm’s right, bonds could reverse some of their losses.

Throw in a less-than-favorable environment for stocks, and bonds’ odds look even better. See, stock market returns in the US have been tracking inflation expectations closely over the past year. That suggests investors see inflation as the “good” kind – i.e. the kind that suggests a surge in demand and strong economic growth – rather than the “bad” kind that comes from supply constraints. But again, that consensus could be completely off the mark.

Source: Bloomberg
Source: Bloomberg

Put simply, an economy that’s once again staring down the barrel of weak inflation could lead to a serious drop-off in stock prices. So if you’re as suspicious as Pimco and Guggenheim that everyone’s been too gung-ho on inflation, you could buy into bonds before everyone scrambles back into them and pushes their prices back up. More satisfyingly still, you might even get to say “I told you so.”

Key takeaways

  • Pretty much everyone – from economists to professional fund managers – thinks the US and other rich countries are headed for inflation.
  • That’s led bond prices to drop from last year’s highs, and encouraged investors to abandon them in favor of stocks that’ll benefit from a reopening economy.
  • But if you agree with Pimco and Guggenheim that inflation will go back to a more sedate pace, you might want to buy into bonds while they’re cheap.
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