As a result of the Covid-19 crisis, inflation expectations have fallen even more. From already very low levels. When, if ever, will inflation ever rise again?
Peter De Coensel, CIO Fixed Income at Degroof Petercam Asset Management (DPAM) and fund manager Sam Vereecke tried to answer this question, which has been haunting investors for the past 40 years, in a webinar.
There’s a straightforward explanation for the fall in inflation expectations. After all, demand has plummeted because of the economic recession that followed the outbreak of the coronavirus. However, the unprecedented monetary and fiscal stimulus that has occurred in response to the crisis, should in principle cause inflation to rise again. Central banks have been printing money at an unprecedented scale. The balance sheet of the ECB accounts for 52.8% of GDP, that of the US Fed 32.6%. In Japan that is no less than 117.8% of GDP. Counterintuitively however, this stimulus has not led to a rise in inflation.
‘In principle, money printing leads to higher prices. However, this has not happened because the velocity of money has been slower and thus the monetary money creation has not been fully absorbed,’ explains Vereecke. ‘QE purchases have largely led to more deposits and reserves with the Fed. But all that money has gone back and forth between the commercial banks and the Fed. So you push money around, but at a rate of zero. That’s not inflationary at all. Only if you let the money circulate can or will you get inflation.’
Gold
Nevertheless, DPAM’s specialists expect the central bank stimulus to eventually lift inflation to somewhat higher levels over the coming years. ‘A bond portfolio is therefore best protected against inflation surprises.’ This could be done with inflation-linked bonds. However, the size of this market is only $3.4 trn, and eurozone core sovereigns do not issue such bonds. Considering investors are also currently pricing in low inflation for years to come, these bonds do not come cheap either.
So what about the alternatives? Gold is a traditional inflation hedge, but it’s not cheap either as it has been the best-performing asset class year-to-date, having risen by more than 20%.
Nevertheless, gold still has the potential to rise further, believes De Coensel. ‘And there is a strong negative correlation between real interest rates and the gold price, so gold is indeed a natural inflation hedge.’