No inflation bogey man lurking on the horizon

Rathbones’ head of asset allocation research Edward Smith looks at a number of inflation scenarios that we believe might play out over the next 20 years, and concludes that there is no reason to fear an inflation bogey man.

By Edward Smith

Our investment report Under pressure? looks at some of the major forces influencing the path of inflation over the longer term, and provides a number of scenarios that we believe might play out over the next 20 years or so. We hope these will be valuable tools for advisers as you help your clients plan for their financial futures.

Some of the structural forces that shape inflation are shifting in interesting ways, but the good news from our analysis is that the balance of evidence doesn’t suggest either a profoundly inflationary or deflationary environment is likely to emerge. In other words, inflation expectations look set to remain well anchored and under control.

The outcome we believe most likely is a benign scenario in which inflation expectations fluctuate only modestly around central bank targets and any inflationary effects of ageing or deflationary effects of technological change are controlled by monetary policy decisions. In this base case scenario, inflation stays in the 1.5% to 2.5% range across the entire 20-year period and we feel there is a 65% probability of this happening, i.e. almost a two in three chance. As we’ve noted in previous blogs on this subject, that should be good news for advisers and their clients – a more stable future is easier to plan for.

We see a period of technologically induced low inflation as the second most likely outcome – one that we believe has a one in five chance of occurring. This scenario covers a range of technological events that could each push prices lower and leave inflation within the 0.5% to 1.5% range over the next 20 years.

We give a very small probability of the final two scenarios happening, just 7.5%, just over a one in 13 chance. The first of these, secular stagnation, is characterised by a world that prefers to save rather than invest. It’s not a pleasant thought for the financial planning industry, but fortunately one we see as very unlikely to come to fruition. In this environment growth would be low, deterring new investments and new technologies would be hard to come by. Nominal interest rates couldn’t be set low enough, and inflation would fall to extremely low levels.

Policy induced stagflation is the final scenario and, in this one, low growth and frequent recessions combine with high inflation. Here, populist policies result in a dramatic rise in government spending and possible withdrawal of central bank independence which un-anchors inflation expectations. At the same time supply is constrained by protectionist policies that move globalisation into reverse. While this may all seem unlikely, the risk of such a scenario unfolding has certainly increased since President Donald Trump took office and the UK’s Labour party has surged in the polls while veering sharply to the left.

Of course the most appropriate long-term investment strategy will depend on the likely path of inflation. For instance, our research suggests that equities typically struggle when inflation falls below 0.5% or rises above 3.5%, while all assets other than gold typically perform worse when both inflation and growth expectations fall at the same time.

In our base case scenario, a balanced, multi-asset portfolio with equities at its core would be likely to have the best prospects for longer-term risk-adjusted returns. In contrast, equities in general are likely to underperform in the policy induced stagflation scenario, although investing in gold may be an appropriate strategy depending on how real yields respond.

Finally, as long-term investors, we are constantly on the lookout for investment themes that might provide a source of return irrespective of fluctuations in the economic cycle. We have touched on a number of such themes throughout our report — ageing, personalised medicine and automation, for example. If you would like more information on these themes, please contact your investment manager.

Visit Rathbone’s inflation hub where you can try our personal inflation calculator and read the full report Under pressure? for a deeper look into the economic themes driving long-term inflation.