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March 31, 2021 | GSAM Connect

Inflation – It's a Jungle Out There

Are We Moving into a Higher Inflation Regime? We revisit this question, which we explored last autumn and last month, given it remains top of mind for our fixed income clients. Following our quarterly Fixed Income Strategy Group (FISG) meetings—where we discuss macro and market themes with economists and investors—we conclude that 2021 will be an anomaly in terms of higher inflation outcomes. We think inflation will land below or close to target in G10 economies in 2022.

 

Inflation – It's a Jungle Out There

The pandemic has led to considerable kangarooing around of goods and services prices but we think many near-term price boosting factors—including higher oil prices and a surge in services spending as economies re-open—will prove transient. The signal from traditional slow-moving inflation signposts—the so-called tortoises—such as slack in the labor market and inflation expectations is subdued. With regards to the three elephants in the room—a surge in global liquidity, sizeable fiscal stimulus and excess household savings (see Exhibit)—we think concerns around these factors creating an overheated economy are overblown.

 

Exhibit: The Extent to Which Excess Savings Are Spent Is Unknown

Household Saving Rates

Source: Macrobond. As of Q4, 2020

 

We're Still in a Low Yield World

Given output and labor market gaps will take time to close, we see limited prospects of central bank rate hikes in major advanced economies in the coming year. In the US, the bar to normalize policy has been raised. The US Federal Reserve (Fed) requires realized—not forecasted—annual inflation to not only reach 2% but also “run moderately above 2% for some time”. In Europe, the central bank forecasts core inflation of just 1.3% in 20231, implying prolonged easy monetary policies through this time horizon. Further out, structural forces, namely aging demographics and retirement savings, continue to exert downward pressure on neutral rates. In other words, a persistence of the low rate environment of the past decade looks more likely than a break to a higher rate world.

Policy Tides Are Turning

The climate transition is ushering in a new era of private and public investment. We think shifts to create a low-carbon economy will increasingly drive security selection investment opportunities across fixed income spread sectors. The pandemic has also amplified investor and policymaker focus on social disparities such as income and wealth inequalities. This is particularly evident in the US with the Fed redefining maximum employment as a “broad-based and inclusive goal”. In our view, inclusive growth goals can have dovish monetary and expansionary fiscal policy implications.

Whilst we recognize—and value—a policy regime shift that is centered on advancing the climate transition and inclusive growth, we continue to think we are in a low inflation and low yield world. As a result, our compass for navigating the ‘status low’ environment is unchanged. We seek to access and diversify across the broad fixed income opportunity set. We also look for openings to capture risk premiums created by market inefficiencies, and we see value in utilizing rates and currencies as a hedge for risk asset exposures. Last but by no means least, we advocate a sustained focus on environmental, social and governance (ESG) analysis2. Overall, our investment views are cautiously pro-cyclical. Improvements in activity have yet to move from forecast to fact, and so we think it would be premature to step back from pro-cyclical exposures.

 

1. Source: ECB. Based on HICP inflation excluding food and energy. As of March 2021

2. See Credit Where Credit is Due: ESG in Fixed Income (January 2021).

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