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Six reasons why inflation may feel like gum on your shoe

04 May 2023

A more active investment strategy is required. Moreover, portfolios construction gets more complicated.

By Sven Schubert,


Sticky inflation has been on the cards since consumer prices started climbing in early 2022 and now it seems a far more probable outcome. After a surprisingly straight downward trend for four months between October 2022 and January 2023, US and Eurozone inflation has started to dig in its heels, and we have identified six reasons for this display of stubbornness.


Elevated inflation is the norm rather than the exception

Elevated inflation levels are the norm for most of recent history. Our analysis shows the higher inflation is allowed to go, the stickier it becomes afterwards. While inflation usually falls fast after its peak; in high-inflation periods such as the 1960-80s, inflation can take longer to retreat and often stabilizes at a higher level than before its rise.

We believe it is questionable that inflation will make a swift return to central banks' targets in a sustainable manner over the next two years unless a deep recession materializes.


Risks of supply shocks linger on

The Covid crisis and the Russia-Ukraine war have severely disrupted supply chains worldwide laying bare global dependencies. The prediction of geopolitically driven price shocks remains an incredibly difficult task, but geopolitical tensions are likely to remain high in Europe (Ukraine/Russia), Asia (Taiwan) and the Middle East (Iran/Israel) and the risk of a prolonged or renewed supply shock is not negligible.

The implications of 2050 zero-carbon emission targets might also have an impact. As households and corporations are incentivised, or even forced to transition to renewable energy sources, supply disruptions and therefore price pressure could easily arise at least in the early stage of the transition.


Inflation is a remedy to growing government debt

Government debt surged over recent years and reached new highs during the pandemic crisis due to massive Covid-related spending measures. While debt creation tends to be inflationary, paying off debt is the opposite. Governments have voiced their willingness to be more disciplined on spending going forward; the question is whether they can.

However, inflation might be a way out. As the nominal value of debt must be paid back, higher inflation will lead to higher nominal government revenues and make it easier for them to repay the debt stock. Even though central banks have a clear duty to fight inflation, financial stability, and sustainable growth matters at least indirectly too, which may tempt them into letting inflation run a bit higher.


Demographics fuel inflation

There are demographic trends that may also have inflationary effects. Generally, an ageing population is assumed to exert deflationary pressure because older people consume fewer goods and services. However, China and India, two major countries that produce many of our goods, will, or do already now, face headwinds, which may lead to wage pressures and rising production costs.

Moreover, the US, is likely to experience a demographic tailwind for the first time since the baby boomer phase of the 1960s, as the working age population will likely rise significantly faster than between 2000-2020. As this group has a high consumption-to-disposable-income ratio, the correlation between core inflation and the growth of this cohort is high.


Supply chain reshuffling drives up production costs

Supply chain reshuffling has gained momentum in recent years. Even though the US and China relationship cooled well before 2016, the Trump administration initiated a trade war triggering a shift of production from China to other Asian producers. This trend gained traction during the Covid crisis and became a necessity more recently with the Ukraine-Russian war.

These disruptions provided the incentive to bring production facilities back into domestic spheres of influence, which tends to be inflationary as corporations weigh supply chain security higher than having production facilities in low production cost countries.


Economies have been running hot

Many countries seem to have overstimulated their economies during the Covid pandemic, with stimulus packages exceeding output gaps caused by the crisis. In 2020, government deficits rose above 11% in G7 countries and have stayed close to 5% until today.

As wage growth and the wage share of national income are rising, the pressure on corporations to pass costs on to the consumer has increased too. As the global economy starts to slow down, labour market conditions may ease, but its resilience argues for at least a couple of quarters for wage growth that is incompatible with the 2% inflation target.


Implications for investors

While the reasons for inflation remaining sticky should be abundantly clear, what does this mean for investors?

Central bank policy has become far more unpredictable, which means market volatility can also be expected to remain above pre-Covid levels. This usually causes higher macroeconomic volatility (shorter business cycles) as well, all of which means that the buy and hold strategies will not work the same way as they used to.

A more active investment strategy is required. Moreover, portfolios construction gets more complicated. Our analysis shows that the positive correlation of equities and bonds is likely to remain in place as long as inflation remains well above central bank targets.

Sven Schubert, is senior investment strategist at Vontobel. The views expressed above should not be taken as investment advice.

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