Is higher inflation lurking around the corner? With warning signs starting to appear, it is one of the biggest questions facing investors. And with record levels of quantitative easing in the system and rising commodity prices – you can see why some are fearful. 
I always remember meeting equity income guru Bill Mott back in 2008 to discuss the effect of quantitative easing on markets. Afterwards, I headed back to the office to Google its impact – the word inflation was all over the search engine. This subsequently led to me re-jigging a number of my investments. More than a decade later and it’s clear Google lied to me! Inflation never appeared, which makes assumptions about an inflationary scenario difficult to unpick on this occasion.
There is a strong argument that the links between government borrowing and inflation no longer apply. Governments are borrowing at unprecedented levels, yet markets continue to scoop up their bonds, some of which are paying negative interest rates.
I recently read an article from the Emeritus Professor of Economics at the London School of Economics Meghnad Desai, which pointed out the alarm bells are simply not ringing on inflation. For example, the ratio of debt servicing charges to GDP (which is a flow-to-flow ratio, and hence a more accurate one to follow than the debt-to-GDP ratio, which is a stock-to-flow ratio) is the lowest it has been for decades.
Desai goes on to argue that while inflationary concerns have been removed since the 2010s, there are elements of a low inflationary economy which have been maturing for 50 years, citing manufacturing moving away from developed countries, services being transformed by technology, and better products being sold at lower prices having all played a role in this long-term change.
Then there is the determination of central banks to manage inflation. The US Federal Reserve, for example, confirmed in their latest economic projections late last year that they do not intend to raise the policy rate for three years. This outlook assumes inflation only rises slowly to reach 2 per cent at the end of 2023.
Schroders’ chief economist Keith Wade points to three potential ways inflation could return to the market. The first of which is that inflation is simply understated by markets, with both measuring services and spending patterns of consumers in the midst of the pandemic shrouding its presence. The second would be that a surge in household spending when we find our new normal will force prices higher. Again, this could take longer than people think, for example some airlines do not expect a return to normality until 2024. The final catalyst would be a supply-side shock – this longer-term trend reflects the structural impact of Covid-19 on the economy. This is where permanent changes in spending patterns could lead to industries going into long-term (and perhaps terminal) decline leading to higher unemployment.
Wade says the initial impact of this supply-side shock would be deflationary as unemployment rises and can persist for some time. Inflation comes later, should governments and central banks misread the high level of unemployment as being cyclical rather than structural. Excess monetary and fiscal stimulus can then create inflation as the economy’s supply capacity is not as great as the unemployment figures would suggest. If forced to choose, I’d say this is the most likely scenario of the three.
As a team, we do not believe inflation will have a significant impact in the short term. We know there is a historic relationship between inflation and interest rates, namely that if you started to see inflation, central banks would panic and then raise rates. But they’ve already given themselves the wiggle room not to do that. We also have significant levels of unemployment across the world. With this in mind we still believe bonds offer value to investors.
If there were higher inflation, the best way to tackle it is by tapping into funds which pay a high enough yield to offer some protection - for example the Baillie Gifford High Yield Bond fund or the Twenty Four Dynamic Bond fund, which pay yields of 3.8 per cent and 4.1 per cent respectively.
Other options beyond bonds might be the Schroder Income Growth fund, which has a dividend of 4.6 per cent or a multi-asset vehicle like the VT Seneca Diversified Income fund, which yields 5.1 per cent.
Darius McDermott is managing director at Chelsea Financial Services. The views expressed above are his own and should not be taken as investment advice.