Analysis

Inflation spike provides investor headache but Federal Reserve reaction crucial

Federal Reserve governors quick to highlight 'transitory' nature of inflation spike

Tom Eckett

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The recent jump in US inflation has given investors plenty to consider, however, the risk of tighter monetary policy from the Federal Reserve triggering another taper tantrum is of even bigger concern.

Last Wednesday, US consumer prices spiked 4.2% over the 12 months to April, up from 2.6% in March, the fastest increase since September 2008 and a long way ahead of the Fed’s 2% target.

Despite the jump in inflation causing market concerns, how the Fed reacts to the data appears to be the number one priority for investors.

“Our biggest risk is how the market will react when the Fed starts to signal a tightening of monetary conditions,” Andrew Limberis, investment manager at Omba Advisory & Investments, said.

So far, Fed governors have been quick to play down the latest figures with vice-chair Richard Clarida stating the acceleration will “only have transitory effects on underlying inflation” while Lael Brainard called on officials to be “patient through the transitory surge”.

This will be music to the ears of investors that are positioning for just a short-term jump in inflation before it settles back down to the Fed’s 2% target.

As Rupert Thompson, CIO at Kingswood, said: “Inflation will pick up sharply over coming months but much of the rise should be only temporary. Continued slack in economies, particularly labour markets, along with the shift to online retail, should help prevent a major rise. We continue to expect inflation to settle around 2-2.5% over the next year or two.”

A look at the drivers behind US inflation’s biggest increase in 13 years provides some clues at why this may be just a temporary phenomenon. Firstly, energy prices have risen some 25.1% over the past year while the price of used cars increased 10% in April and the economy is recovering from the coronavirus pandemic.

“Over the coming months and years, we expect that some of the supply-side bottlenecks will ease but will be partly offset by additional inflation in services as consumers demand for services rises post-pandemic,” Limberis added.

Echoing his views, Jordan Sriharan, head of MPS and passive at Canaccord Genuity Wealth Management, said the long-term outlook for inflation remained more benign.

“In the long run, the infamous three Ds – demographics, debt and deficits – remain a significant impediment to inflation becoming more deeply entrenched,” he continued. “This is why central banks continue to describe today’s inflation picture as transitory.”

Inflation protection

In this environment, there are a number of ways investors are positioning themselves. Limberis, for example, has started to reduce the duration risk of the firm’s US Treasury holdings while also increasing a focus on equities.

“The ability of equities to protect against inflation is probably most important and for the most part we think that US companies would be able to protect their margins by passing on prices to consumers, some of whom have received savings boosts through US fiscal and monetary responses.”

When looking to incorporate inflation protection bonds, Sriharan highlighted the Tabula US Enhanced Inflation UCITS ETF (TINF) as “the most appropriate exposure” for portfolios.

By combining exposure Treasury Inflation Protection Securities (TIPS) and breakevens, TINF captures both a rise in inflation expectations and realised inflation.

“It will generate higher returns than TIPS if our assumption is that breakeven rates and nominal yields rise,” he added.

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