The New Nominal

How much did your cup of coffee cost this morning? Was it more than it was a year ago? For many around the world it would certainly seem so, with the inflation debate taking centre stage in the media and around dinner tables (or café tables!).

Inflation is the rise in cost in an average basket of goods and services (measured by the consumer price index) – a high inflation rate means that the cost-of-living increases, putting pressure on household finances and also eroding the “value” of money (i.e., $100 buys you 20 coffees now but may only buy 18 in a years’ time if their price increases).

The higher inflation gets, the less chance there is that savers will see any real return on their money.

"The most important thing to remember is that inflation is not an act of God, that inflation is not a catastrophe of the elements or a disease that comes like the plague," said the Austrian philosopher and economist Ludwig von Mises.

"Inflation is a policy."

Indeed, in an inflationary environment central banks are able to raise interest rates to slow down the rate of inflation.

However, policymakers now find themselves in a bind. In the current environment rates are being kept low in many markets to spur growth which decreased through global lockdowns. The Federal Reserve in the US have recently said they would be willing to allow inflation to rise as it keeps interest rates low. The RBA in Australia have been purchasing government bonds to keep interest rates low.

It’s also important to note the unique circumstances of the pandemic environment. Global supply chains have been rewired in response to restrictions and complications that COVID 19 has posed. Higher production costs, combined with unprecedented fiscal and monetary support, have fuelled inflationary pressures.

In Australia, fiscal stimulus, built up savings and low interest rates have all led to an increase in discretionary demand for durable goods. Mix in the supply chain issues that have plagued many of these price sensitive good sectors and the inflation narrative starts to look a lot like the overseas experience to date.

Given all this, and with the recovery out of recession being stronger and faster than expected, the risk of inflation is becoming more real.

BlackRock’s Investment Institute believe this “new nominal” will be one of the key themes driving markets in the medium term – a higher inflation regime with a more muted monetary response than in the past.

What then, are the implications of this for your portfolio?

Firstly, it’s important to note that some of the traditional inflation friendly investments such as real estate, commodities and precious metals pay little or no income and many investors don’t hold enough of these in a portfolio to properly guard against inflation.

As such, Fixed income remains a crucial part of investment portfolios. Even in a low interest rate environment, fixed income may provide risk diversification benefits which serve to protect portfolios in an equity market sell-off.

That said, the “new nominal” begs the question – what sort of Fixed Income should investors hold?

While we still advocate maintaining exposure to both government bonds and corporate bonds, we see Inflation Linked Bonds as a tool to help inflation-proofing your portfolio.

Inflation linked bonds primarily have medium to long term maturities and are typically issued by sovereign governments. These bonds have their principal amount and coupons linked to the rate of inflation. In this way the investor receives at maturity an inflation adjusted or ‘real’ return of their capital. Similarly, if inflation increases then so do the coupons paid on the bonds, and vice versa.

Given the desire of investors to maintain and grow the purchasing power of their savings through investing, you can understand why these deserve a place in a portfolio. Flows into Inflation Linked Bonds ETFs globally have been strong since the beginning of 2021. See chart 3 below.

BlackRock’s iShares Inflation Linked Bond ETF (ILB) offers exposure to Australian Commonwealth and State government inflation-linked bonds, all of which are considered safe, credit worthy issuers. When used alongside other shorter duration exposures such as iShares Yield Plus ETF (IYLD) and iShares Core Corporate Bond ETF (ICOR) in a portfolio, may help maintain broad, Investment Grade exposure, but with additional Inflation protection.

With Interest Rates kept low to spur the recovery from lockdown and pandemic-related supply chain disruptions continuing, a higher inflationary environment in Australia appears inevitable.

That said, fixed income remains an important part of an investment portfolio. For instance, Inflation linked bonds can potentially help to alleviate the effects of inflation on your portfolio and leave you well equipped for this “new nominal”.

Investors can implement their view through cost effective and transparent ETFs.

With a well-positioned portfolio, you can have more confidence you won’t need to sacrifice that morning coffee.