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October
01
2021

U.S. could be heading into an ‘era’ of high inflation that produces paltry, or even negative, real returns on safe assets, analyst warns
Vivien Lou Chen

A Chinese worker stands inside the Zhangbei Flexible DC Power Network Project that provides electricity. Power cuts in China are one of the factors driving up fears about inflation worldwide.

The U.S. may be heading into an “era” in which inflation remains significantly higher on average over the next decade, according to London-based research firm Capital Economics.

In a note this week, John Higgins, its chief markets economist, puts a new spin on the inflation debate, by theorizing that price gains won’t necessarily climb sharply from here, or be accompanied by weaker economic growth and tighter monetary policy. In that case, he says, markets won’t falter the way they have during past periods of high inflation.

The prospect of persistently higher inflation worldwide is gaining traction after the heads of the Federal Reserve, European Central Bank, Bank of England and Bank of Japan  acknowledged on Wednesday that the spike in price gains seen in many advanced countries this year may stay elevated for some time. Over the past week, worries about inflation and the prospect that the Fed might need to tighten monetary policy more aggressively down the road were factors behind the runup in Treasury yields, which caused stocks to falter and the U.S. Dollar Index to spike.

A crackdown on the energy sector in China, record energy prices in Europe and cargo pile-ups at California ports are some of the events that have once-complacent investors considering the notion of longer-lived priced gains, even if they haven’t been fully priced in yet. The forecast from Capital Economics goes further out than most firms’ expectations, while delving into the impact on bonds, stocks and currencies. 

“We envisage a future in the US in which inflation is significantly higher than it has been in the past decade, but still only moderately above target; economic growth remains healthy as supply constraints ease; and the Fed doesn’t press very hard on the brakes,” Higgins wrote in a paper titled, “What would an era of higher inflation mean for markets?” 

His firm’s base-case view assumes that inflation will remain below 5% in most advanced economies and many emerging markets, though “the risks to this view lie more to the upside than the downside,” he said. The headline U.S. consumer price index rate could average around 3% later this decade, compared to the sub-2% level that prevailed over the 2010s. And U.S. monetary policy could remain “very accommodative” in the next few years, considering the Fed’s flexible average inflation targeting approach. 

What that means for financial markets is that real, or inflation-adjusted, returns on low-yielding, safe U.S. assets like Treasury bonds “will be paltry, or even negative” in the next few years or more, according to Higgins. But those of the most risky U.S. assets, like stocks, “will be positive,” even if real returns “fall far short” of the “spectacular” returns seen since early 2020.

On Thursday, U.S. stocks rose as Wall Street aimed to wrap up the last trading day of September and third quarter. The Dow Jones Industrial Average DJIA, 1.46%  was down by around 0.5% and the S&P 500 index SPX, 1.14% was lower by 0.1%, while the Nasdaq Composite Index COMP, 0.65%was up 0.3% early in the session. 

Treasury yields have stabilized, with the 10-year rate TMUBMUSD10Y, 1.478% hovered around 1.53% and 30-year TMUBMUSD30Y, 2.057% rate at roughly 2.08% — both still headed for the sharpest monthly rise since March. Meanwhile, the U.S. Dollar Index, DXY, -0.22%, continued to hover around a one -year high.

For currencies, an era of higher and less stable inflation in many major economies “would result in a rise in exchange rate volatility and, over time, the depreciation of the currencies of those countries which experience higher inflation,” according to Jonas Goltermann, a senior markets economist at Capital Economics.

Among developed economies, the U.S., the U.K., Canada, and Australia “are more at risk of sustained higher inflation,” Goltermann wrote in a note Thursday. This suggests “that their currencies will weaken in nominal terms relative to the currencies of many European and Asia economies, where we expect inflation to remain subdued.”

Within the group of major emerging markets –aside from Argentina and Turkey, where inflation has already been in double digits in recent years — “Brazil, Colombia, South Africa, Indonesia, and the Philippines are at risk of a significant pick up in inflation, which would undermine their currencies,” he said.

 

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