Updated: Mar 22
This article discusses the current wave of inflation in major global economies and the opportunities that monetary policy actions could bring. We also dive into how international investors with exposure to any of the affected economies should position their investment portfolio to maximize returns.
There is a current wave of inflation in major global economies caused by a combination of factors that affect most countries. These factors range from soaring energy prices from the Russia-Ukraine crisis, supply chain disruptions, bad weather conditions, and surging demand from the lifting of covid-19 restrictions following successful vaccine rollouts. The inflation rate in the US, which is at a 40-year high, is primarily due to supply chain bottlenecks and surging consumer demand, while base effects also play a contributory role.
In Germany, supply chain disruptions, VAT rate hikes, bad weather conditions, base effects, and higher energy prices contributed to steadily rising inflation. Inflation reached 5.3% in December 2021, hitting a 30-year high, well above the European Central Bank’s (ECB) inflation target of 2%.
Canada and Australia are also experiencing relatively high rates of inflation. In January 2022, the inflation rate in Canada hit a 30-year high at 5.1%, far above the Bank of Canada’s benchmark rate, which currently sits at .25%. The current inflation run is driven by pent-up demand, unfavorable weather conditions, and supply chain disruptions. In Australia, Q4’21 inflation went up 3.5% year-on-year on the back of record fuel petrol prices and the cost of building new homes, the highest in two decades.
All the factors mentioned above have significantly pushed up prices across the globe and fuels speculations that monetary policies are going to shift to a tighter regime to tame inflation. Presumably, inflation will be controlled through contractionary economic policies via interest rates increases and the ending of quantitative easing (QE) in countries where QE is applied. Whenever financial markets anticipate interest rate increase, massive asset selloffs are triggered, as prices across most markets trend downwards while investors move to maximize cash proceeds. Active investors move for portfolio re-allocations to take advantage of opportunities that a tighter interest rate environment brings.
When authorities eventually increase interest rates, the demand for financial assets declines as investor sentiment decreases, causing asset prices to fall. The falling asset prices are mainly due to reduced investors’ capacity to borrow due to higher borrowing costs.
In this context, active investors have a higher risk appetite and seek short- to medium-term opportunities. They constantly monitor the markets to exploit openings, such as underpriced assets. Profitable investment actions are made possible by allocating more investments to cash. If an interest rate hike is established, timing an early exit from the market is crucial to maximizing cash proceeds before asset prices tumble.
Just as mentioned earlier, anticipating the actions of monetary policy authorities is crucial for investment success. Bondholders, who are relatively risk-averse compared with equity holders, are not left out to reposition their portfolios to capitalize on the anticipated interest rate hikes. Active bond investors would want to rebalance to maximize returns, while passive bondholders would be looking to take a defensive position to hedge against a drop in average yields.
Would the rate hike be gradual, or would it be a sharp increase? If there is market consensus about a sharp rise in interest rates, this will trigger massive asset selloffs. A sensitivity analysis would throw more insight into the extent of the increase and the probable impact on the investment portfolio. In addition, it would also be essential to understand what are the underlying drivers of inflation. Is inflation driven by demand, causing the economy to run too fast? If high inflation is majorly demand-driven, increasing interest rates is inevitable.
Also, for bondholders, the term structure bonds with short to medium-term maturities would be tilted towards cash as the market moves to a period of lower valuations for bonds. Lower valuations are due to lower yields compared with newer issues that would have to come with higher yields to be considered investment-worthy in the light of higher interest rates.
Another critical factor that bondholders monitor closely is the term structure of interest rates such as yield curve, forward rate curve, or spot rate curve. These curves highlight profitable maturities and help determine the portion of a bond portfolio to sell off and the part to hold. Investors would critically analyze bonds with short to medium maturities, against future spot rates. In a period of high inflation, future spot rates are expected to go up because of policy actions by monetary authorities. The values of this category of bonds will be affected by higher interest rates which, in turn, negatively impact bond values.
Active bondholders analyze forward contracts against forward rate curves. If an investor enters into a forward contract to buy bonds, future spot rates are analyzed to determine investment actions. Just as mentioned above, if future spot rates are expected to go higher than forward rates, forward contracts would be sold because the valuation of such instruments would decrease.
In conclusion, when inflation is persistently high, the markets would expect monetary authorities to hike interest rates, and portfolio adjustments are made accordingly. Active investors would position portfolios by tilting towards cash to maximize proceeds and would look for a good re-entry in a bottoming market to maximize returns. Bondholders would monitor the yield curves and act accordingly. Also, bondholders with short to medium maturity bonds would either tilt the portfolio to longer-term maturities or sell the bonds and enter a forward contract to buy bonds that would yield higher returns. Timing is of essence to increase the likelihood of maximizing portfolio returns or minimizing yield drops as the case may be.