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Blogs

Q&A: Inflation insights

Dave Donabedian, CFA

September 15, 2021

From the desk of CIBC Private Wealth Chief Investment Officer, Dave Donabedian, CFA

Q: What is your current view on inflation (transitory, going higher, stable at higher level than in prior years), and what does that mean for the general population?

A: The current pace of inflation as measured by the consumer price index (CPI) is running above 5%. We believe this pace will calm down over the next few months; however, we think it will remain well above the Federal Reserve’s (Fed’s) 2% target for many more months, challenging the Fed’s “transitory” scenario. For households, a higher inflation rate cuts into real wage growth, unless wages are also rising. In today’s world, we do expect an acceleration in wage growth given tight labor markets, so the macro impact of a somewhat higher inflation rate may be small.

Q: What factors/signals are you monitoring to determine the future direction of inflation?

A: We are focusing on four things:

1. Pandemic-related price shocks (hotel rates, airline fares, etc.). We do expect these to normalize and put less upward pressure on the inflation rate.

2. Supply shortages (car prices, semiconductors). We believe these will persist for at least another six months, though most of the price increases have already occurred.

3. Wage pressures. Two-thirds of corporate cost structures are employee compensation. We expect wages to rise, which may feed into a willingness to pay higher prices.

4. Shelter costs (41% of core CPI). If there is any relation between the real world and government data, the surge in home prices and rents should seep into the government statistics in the months ahead. This is the primary reason we expect inflation to remain stubbornly high longer than the Fed and markets will be comfortable with.

Q: Given your current views on inflation, what would be its impact for different asset classes?

A: Higher bond yields are likely for the fixed income space. We expect to finish the year challenging the 1.75% level on the 10-year Treasury.

Most companies are showing the ability to pass on cost increases, so we expect a strong earnings environment for equities. The impact of higher bond yields will add to equity market volatility, but we believe the bull market can survive a bout of higher inflation. History suggests that equity markets do fine when inflation is low but rising. We expect the “new normal” for inflation to be 3% instead of 2%—not a killer for the stock market.

Q: Given your current views on inflation, what (if any) adjustments would you make to your portfolio positioning for that environment?

A: We have worked some inflation hedges, including a diversified commodities pool and floating-rate debt, into our asset allocation models. We recommended low exposure to core fixed income, as we expect yields to rise.

Q: Many view a return of persistent and uncomfortably higher inflation as a risk to financial asset returns. What are you looking for as evidence that such an environment is unfolding, and what (if any) adjustments would you make to your portfolio positioning for that environment?

A: The biggest risk to markets would likely occur if inflationary expectations moved permanently higher—beyond the 3% area that we think is likely. A sustainable inflation rate higher than that implies the need for much more aggressive central bank tightening, with potential negative implications for economic growth and credit. We follow consumer inflation expectations through surveys, and investor inflation expectations through the futures and swaps markets. If these indicators showed that households and investors expected a high inflation rate to persist, it would be bad for both bonds and stocks.

We would look to underweight both, and lean on inflation hedges like commodities, real assets and infrastructure. At some point, the Fed’s policy response (rate hikes) would also produce a decent return on cash. To be clear, this is not our baseline scenario, but we are always prepared to adjust portfolios, as necessary.

 

Dave Donabedian, CFA is chief investment officer of CIBC Private Wealth Management, serving in that capacity since 2009. His responsibilities include chairing the Asset Allocation Committee, as well as providing oversight of internal investment strategies and the external manager selection platform.