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Will inflation stop the party
31 May 2021

Over a year since the pandemic hit the world, jolting economies and markets, investors can now safely say that their portfolios are in very different positions than they were last year, with equities almost registering the same rate of growth in the first five months of 2021 as they did throughout all of 2020. 

Now that equities sit comfortably on good gains, focus turns on the topic of inflation that rightly-so has cropped up in the wake of such a recovery.

Before we delve into this topic one must consider the starting point which led to the current position. Namely, the unprecedented halt experienced due to the onset of COVID-19. Unlike previous recessions that were triggered by the natural forces of an economy – supply and demand, this recession was unprecedented in that it completely stopped economic activity. This means there is nothing natural about the cycle we are in. The same applies for the measures implemented to counter its effects, with central banks and governments wielding their full force with rapid stimulus measures as they never had before.

Now that vaccinations programmes are underway and economies are reopening, the world is experiencing a strong surge in economic activity, driven by consumer pent-up demand and revenge spending to make up for lost time. Moreover, whereas last year we saw consumers panic buying and stocking up supplies ahead of lockdowns, now it is companies that are piling inventories and looking to increase their workforce, to meet client demand. This is leading to shortages and bottlenecks, which in turn is driving an increase in prices, also referred to as an inflation surge. Whereas inflation is always present, and is healthy when stable, a rapid increase in inflation leads to uneasy suppliers that experience a quick rise in costs for their inputs, putting pressure on them to pass on these higher costs to the consumer to avoid squeezing profit margins.

Such a scenario drives investors to fear for many reasons. A rapid surge in prices dilutes consumers’ purchasing power and eventually leads to lower demand as households will not be able to afford the same quantity of goods as they did before. This in turn translates to lower selling volumes from the companies’ side and lower profit margins. In addition, or rather, more importantly, such dynamics trigger central banks to tighten monetary policy and control inflation by raising interest rates i.e. raising borrowing costs for companies.

These fears showed signs of manifestation during the second week of May where we saw global equities dropping circa 3.5% in four days as investors sold their positions and locked in their accumulated profits.

The question one asks now is: Where will these funds be directed? And here is where the soon-to-be year-old acronym TINA prevails. TINA stands for ‘there is no alternative’, a phrase used in conjunction with equities, as amidst low interest rates, with bonds offering such low yields and cash not a worthwhile option, equities were the only viable alternative for earning good returns. Now that we find ourselves in a scenario with rising inflation, bond yields are expected to rise to that effect, pushing bond prices lower. This makes bonds less attractive and can be argued that again, this leaves equities as the only suitable alternative.

One might also argue that these inflationary trends might be transitory, correcting for the unprecedented halt mentioned earlier, and that once economies restabilize themselves onto regular activity levels, supply and demand forces will automatically correct and stabilize the level of inflation accordingly. Moreover, technological disruption has contributed to inflation remaining relatively low throughout this decade, as digital innovation pushes costs lower.

A surge in inflation can also be seen as an indicator that economic activity is picking up, a positive for companies and their prospects for earnings growth. All this leads us to the conclusion that TINA will keep on rolling and equities are expected to continue remaining the more attractive asset class available for investors to enhance their risk-adjusted returns within their diversified portfolio. This does not mean that all equities will outperform. During such times the importance of selection is key as ever, to identify those areas within the equity space that will fare better in an inflationary environment.

This article was written by Christabel Camilleri and published on the Sunday Times of Malta on the 30th May 2021. Christabel Camilleri Saliba, CFA, Portfolio Manager at BOV Wealth Management

This article is not, and nothing in it should be construed as a recommendation in respect of investment products or services offered by the BOV Group.  Any views, assumptions or opinions expressed in this article are those of the author. Value of investments may go down as well as up and may be affected by changes in currency exchange rates. Past performance is not a guide to future performance. Issued by Bank of Valletta p.l.c., 58, Triq San Żakkarija, il-Belt Valletta VLT 1130.  Bank of Valletta p.l.c. is a public limited company regulated by the MFSA, licensed to carry out the business of banking and investment services in terms of the Banking and Investment Services Acts (Cap.370, 371 of the Laws of Malta).  
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Bank of Valletta p.l.c. is a public limited company regulated by the MFSA and is licensed to carry out the business of banking and investment services in terms of the Banking Act (Cap. 371 of the Laws of Malta) and the Investment Services Act (Cap.370. of the Laws of Malta).