Inflation expectations just reached their highest levels in a decade and that has some investors on edge. Every week we see additional news coverage about resurgent inflation and rising longer-term interest rates.

In the world of fixed income, interest rates and bond prices tend to move in the opposite direction making some investors concerned about the declining value of their bond funds. Stocks, too, may be impacted in a slightly different way. Already, rising input costs have begun to crimp profit margins and growth stocks with high valuation multiples are beginning to slide.

Inflation expectations were stoked this year by the increasing likelihood of a large US fiscal stimulus package, early signs of progress for vaccine roll-outs and pent-up demand from consumers previously stuck at home. Pent-up demand was evident in last month’s US retail sales report which posted a surprisingly sharp 5.3 per cent month-over-month increase, blowing away economists’ consensus estimates for just a 1.1 per cent improvement.

According to Bloomberg data, the inflation rate, as measured by the Consumer Price Index (CPI), is expected to rise from 1.2 per cent in 2020 to 2.2 per cent this year. Top economists disagree on the exact number, but overall forecasts have been on the upswing. For example, Moody’s Analytics is looking for a 2.9 per cent inflation rate in 2021, while PNC Financial is calling for a 1.6 per cent rise.

The large dispersion is due to the numerous uncertainties involved in the reopening process. On this point, the International Monetary Fund (IMF) opined in their latest report, “Surging infections in late 2020 (including from new variants of the virus), renewed lockdowns, logistical problems with vaccine distribution, and uncertainty about take-up are important counterpoints to favourable news.”

Besides the headline CPI number, analysts also pay attention to the ‘breakeven inflation rate’ used to gauge anticipated inflation levels. The breakeven rate is a market-based measure of expected inflation calculated by taking the difference between the yield of a regular US Treasury bond issue and an inflation-linked bond of the same maturity. Using current levels on the 10-year bonds reflects what market participants expect inflation to be over the next decade.

Following a sharp spike up in yields this month, the 10-year bond is currently yielding 1.36 per cent while the current yield to maturity of the treasury inflation protected security (TIPS) bond is -0.80 per cent. Calculating the difference between the two market-based rates shows an expected inflation level of 2.16 per cent and this represents a substantial rise from below 1 per cent in the spring of last year.

Other signs of higher inflation can be found in soaring commodity prices and in the resurgent producer price index (PPI). Since last September, the Bloomberg Commodity Index, a composite index of commodity prices, has risen 22 per cent and now surpasses its pre-pandemic level. Meanwhile, West Texas Intermediate oil prices punched up through $60 per barrel this month just as copper prices spiked over 15 per cent in February, so far.

The producer price index is another popular inflation index which tracks the costs of goods from the viewpoint of the industries which make products. In January, the US PPI index increased by a seasonally adjusted 1.3 per cent – the largest advance since the index was launched in December 2009. Whether or not higher manufacturer’s prices show up in consumer prices ultimately depends upon the strength of final demand and if producers are willing to absorb higher costs.

While recent increases in inflation expectations and commodity prices are concerning, some economists argue that the snap back in prices primarily reflects a supply bottleneck created during the lockdown which could quickly dissipate as activity continues to normalise. Furthermore, commodity prices might be kept in check by additional supply, such as new oil rigs coming on stream in the energy market. A time-tested economic axiom states that nothing solves higher prices like higher prices.

The US Federal Reserve is closely watching inflation rates to determine if this year’s uptick is more of a short-term pop versus a longer-term process of creating sustained inflation. The Fed has made it clear that it welcomes an increase in inflation of up to 2 per cent and maybe a bit higher. But inflation above that level on a non-transitory basis might eventually provoke a shift in central bank policy.

Still, the Fed’s other mandate of supporting full employment will likely receive a higher priority in the near term. The US unemployment rate was 6.3 per cent in January, far above its low of 3.5 per cent posted early last year. Restoring businesses, pummeled by pandemic-related government mobility restrictions and bringing unemployed citizens back to work, will likely take priority over capping prices. Therefore, we do not expect any movement in short-term interest rates for at least the next several months.

Given the potential for further inflation, investors should consider having some inflation protection in their portfolios. These assets may include treasury inflation-protection securities (TIPS), real estate owned directly or through real estate investment trusts (REITs), commodities and common stock of companies able to pass higher costs on to their consumers. Innovative companies which are disrupting traditional business models through cutting-edge technology and cheaper small-cap-value stocks are good bets in this environment.

Bryan Dooley, CFA, is Head of Portfolio Management at LOM Asset Management Ltd. Please contact LOM at 441-292-5000 for further information. This communication is for information purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, investment product or service. Readers should consult with their Brokers if such information and or opinions would be in their best interest when making investment decisions. LOM is licensed to conduct investment business by the Bermuda Monetary Authority.