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According to Principal Global Investors, investors need to prepare their portfolios for a spike in inflation

After falling almost to zero during the worst moments of the COVID-19 pandemic, the US inflation rate is increasing. In order to cope with the current market environment, according to Principal Global Investors, investors must understand how quickly inflation will generate recovery of the US economy, for how long this inflation will continue and what consequences it will have for investment.

After almost ten years in which inflation has not been a cause for concern, several factors now seem to be aligning that are driving it up. In February 2021, the US consumer price index (CPI) had risen to 1.7% year-on-year, and in March it had risen to 2.6%, its highest level in more than two years. Investors are concerned, and not without reason, that the CPI could register an even greater rebound between now and the end of the year.

If it were a lasting rebound, could lead the authorities to withdraw the stimulus measures before the full economic recovery, which in turn would have consequences on interest rates, asset prices and the construction of investment portfolios.

In this article, we will talk about how inflation has gone from being in the background to becoming one of the main concerns of investors, as well as what investors can do to anticipate the rebound.

The return of inflation: factors to consider
In early 2021, inflation quickly replaced COVID-19 as the main concern of investors. The big change began last year, when the US implicit inflation rates, which are a measure of future inflation expectations, fell markedly in response to the disinflationary episode caused by COVID, before registering a progressive recovery.

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Implied inflation rates are now at their highest level since the end of 2018. (Market-based inflation expectations are determined based on the implied inflation rates of TIPS, or US Treasury Inflation Protected Securities. , which measure the difference between the nominal yield of Treasuries and the yield of comparable TIPS)

In recent months, the implicit inflation rate curve has inverted, indicating that the markets anticipate an immediate, albeit transitory, rebound in inflation in the coming months.

In summary
After falling almost to zero during the pandemic, inflation has become the main concern of investors.

The great return: Concern about inflation reappears when implicit inflation rates rise. A spike in inflation would have an effect on interest rates, asset prices, and investment portfolios.

Mitigating factors: lhe conditions related to COVID-19 favor an increase in inflation. But unusual base conditions are not the only factors influencing a spike in inflation. Other market conditions indicate that certain inflationary effects, such as sustained pressures on prices, could last over time, at least in the short term.

Consequences for investment: Inflation has been at low levels for many years, so many investors are unprepared for the effects it could have on their portfolios. In order to anticipate the rally, investors may choose to increase their exposure to assets that are likely to perform well.

Rising prices
The transitory nature of the anticipated rise in inflation is partly due to the unusual nature of 2020. Year-on-year comparisons will almost inevitably rise as a result of the sharp drop last year. Similarly, inflation could decline when last year’s drop caused by the pandemic disappears from the annual comparison.

Although it is true that there are ‘base effects’, there are other effects, such as the unusual nature of the pandemic, which brought with it Large-scale fiscal stimulus measures after the initial demand crisis, the closure of economies and the recovery driven by vaccines, which have caused a change in the dynamics of inflation, especially in certain segments.

Increase in export prices due to supply restrictions. Import prices are a good example. Last year, pandemic-related closures caused supply problems in global supply chains. When demand accelerated due to fiscal transfers and improved COVID conditions in many economies, supply problems continued, and prices rose. If supply fails to keep up with demand, price increases caused by restrictions are likely to continue in the coming quarters. More worrying is the possibility of sustained price pressures.

Take, for example, a rise in commodity prices, or a prolonged spike in gasoline prices. These pressures affect the day-to-day life of consumers and could also harm the long-term economic growth. Following the extraordinary fiscal and monetary policy measures that were implemented after the pandemic, there has already been an increase in the average price of unleaded gasoline, which has gone from below $ 1.80 in a single year to almost 2.90.

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