Catherine Doyle continues Newton Investment Management's series of DC columns with a look at inflationary and deflationary risk
Over the last two years there has been a significant focus on a cyclical pickup in consumer-price inflation, particularly in the US economy, which is seen to be leading the current cycle, while closer to home, the sharp devaluation of sterling has created some potentially short-lived inflationary pressures. Inflation is, of course, just one of the risks faced by defined contribution (DC) investors, but it is nonetheless a material concern when considering how to sustain and support a lifestyle in retirement.
For some time, our view has been that fears of inflation are overblown, owing to a number of factors such as globalisation, demography (the population in certain parts of the world is ageing fast), and the vast ballooning of debt. Indeed, with structural disinflationary headwinds remaining and the economic cycle even at this late stage making pricing power a scarce attribute among companies, the risk that other developed economies could emulate Japan's long-term experience of zero or little inflation looks quite high, all other things being equal. Of course, other things are hardly ever equal and it is worth considering that, having become locked into a relatively predictable trend of contained inflation for many years, the end of this current cycle may potentially lead to a more extreme outcome in one direction or the other.
The risks on the inflationary side are likely to stem from political developments. Disinflation has gone hand in hand with the world opening up. Although globalisation is not in full retreat, frictions are growing in terms of free movement across the economic spectrum, from people and goods to technology transfer. Most are aware of the dangers of outright protectionism, but populist politics has been in the ascendancy in the mature economies. In the next downturn, central bank balance sheets could conceivably be taken under political control, with ideas like ‘people's QE' (funding tax cuts) or MMT (modern monetary theory), which advocates the monetary financing of government deficits, potentially being taken up.
How can we navigate this new era from an investment perspective, and ultimately provide the best outcome for DC members in their portfolios? Regardless of whether the scenario is deflationary or inflationary in nature, the new post-quantitative easing backdrop is likely to be different from the last 30 years. The global economic uncertainty index shows that such uncertainty is now more acute than at the height of the global financial crisis1, and it is possible that historic correlations between equities and bonds may continue to break down. The importance of having an active, flexible portfolio and the ability to calibrate key risks such as inflation is likely to come to the fore. Employing the necessary skills to adjust a portfolio to embed inflation protection, for example, through assets that have little sensitivity to the economic cycle, creates a higher probability of providing a smooth investment journey that meets DC members' future requirements.
Catherine Doyle is head of defined contribution, UK, at Newton Investment Management. Email: [email protected]
1 Source: www.policyuncertainty.com, April 2019
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