The Return of Inflation: A Conundrum?

As with millions of other bank account holders, I have recently received correspondence from my bank warning over the prospect of negative interest rates. In effect, banks wish to charge me for holding cash on deposit. At a time when inflation has risen to 2.1% in the UK (higher than expected in May) and 5% in the US, the timing of this bank correspondence might appear rather strange.

Global equity and bond markets are priced on the expectation that this rising inflation is transitory as opposed to persistent as a result of factors such as the base effect from 12 months ago and increased oil and other commodity prices. Amid the rebound in the economy, labour shortages and wage rises are being widely reported in the economy with 881,000 recorded vacancies in May. Meanwhile, the UK government’s furlough scheme has been extended until the end of September. This scheme in itself is creating labour shortages as employees remain on company payrolls thereby supressing what otherwise would be a higher unemployment rate. With a continuing output gap, the outlook for inflation won’t be known for another 6 months as the economy recovers in the post pandemic, vaccinated world.

The 10 year gilt in the UK currently delivers a gross redemption yield of 0.76%. In the US it is 1.5%, counter intuitively having hardened of late (it peaked in February) in the face of rising costs. In Europe, Italy is the only country with positive 5 year borrowing costs. Even Greece now has negative rates.

Central bankers across the western world do not  wish to see a tightening of financial conditions. The Federal Reserve looks set to continue its £120 billion of monthly bond purchases but has brought forward the date of expected interest rates to 2023 from 2024. They clearly wish to avoid a repeat of the ‘taper tantrum’ which followed the GFC and led to volatility in markets.

As with equity and bond investors, the interest rate and inflation outlook are fundamental also to property investors. At Advent Capital Investments Ltd, we continue to monitor these variables closely. However, over time, property returns are more correlated with GDP growth than inflation. In the past, higher interest rates have derailed the property sector but the market remains lowly leveraged with plenty of caution evident with lenders and so the risks do not seem high at this point. More of a risk is an unexpected rise in the risk free rate but this does not seem probable given policy makers’ actions and inflation being given the benefit of the doubt in terms of its longevity.

With a UK Base rate of only 0.1% it is tempting to think that the next move will be upward but my bank still feels the need to warn of a move to negative rates. Let’s hope this caution is misplaced.

James Thornton - Non-Executive Chairman