Just over a year ago, the International Monetary Fund (IMF) called inflation “the dog that didn’t bark” in reference to the remarkably stable rates of consumer price inflation in the wake of the 2008-09 financial crisis. One year later, that dog remains silent. But as any dog owner knows, assuming it stays that way can be a bold assumption. It is important that investors do not become complacent in the face of changing fundamentals. In both the US and the Eurozone, inflationary dynamics are becoming more challenging, albeit in different ways.
Improved employment in US could lead to greater inflation
In the US, continued improvement in employment data has reduced spare capacity in the labor market, which suggests we should see greater inflation and capital expenditures this year. The market’s focus on rising Fed rates is likely to intensify and should result in higher Treasury yields and a stronger US dollar.
The Eurozone is flirting with deflation
Meanwhile, the Eurozone’s flirtation with deflation has, in our view, transformed the perceived limits of European Central Bank (ECB) policy, similar to when the Outright Monetary Transactions (OMT) program was announced during the 2012 sovereign debt crisis. At the most recent ECB press conference, President Mario Draghi opened the door to an asset purchase program should inflation expectations become unhinged. This willingness to consider quantitative easing, which now seems implicitly supported even by the German Bundesbank, provides an additional layer of “insurance” to the Eurozone’s economic growth and corporate health.
As a result, we view the recent financial market weakness as a buying opportunity. We will, of course, continue to monitor the situation in Ukraine closely and would review our position in the event of a sustained rise in energy prices or prolonged supply disruption. But, for investors, attempting to anticipate geo-political developments and trade risk premiums is likely to prove a losing strategy. We consider it best to invest based on fundamental economic developments and react, as necessary, to geopolitical events as they occur.
Overall, inflation worldwide is likely to remain contained, even if growth improves in developed markets. However, it must not be ignored. Dynamics are changing and diverging, and central bank responses to these shifts will prove a key driver of markets in the years ahead.
The best way of protecting against inflation, we believe, is to invest in assets. Such a strategy particularly pertains to wealthy individuals, since rising asset prices may influence inflation perceptions more than the prices of other goods included in economists’ inflation baskets. Equities, which represent claims on the future income produced by the real assets of a business, should rise over time in tandem with overall prices. We advise investors to review their strategic asset allocations to ensure they have adequate exposure to shares and limited exposure to cash.
To understand more about how these trends may impact your individual investments and strategy for the year, connect with your UBS Financial Advisor or find a Financial Advisor.