The highly-anticipated jump in U.S. inflation has arrived. While the sustainability of the increase remains open for debate, recent readings have surged and market-based indicators continue to show a surprisingly prolonged increase in inflation expectations. In particular, following today’s strong CPI report for April, U.S. 10-year inflation breakevens stepped up to a fresh cycle high of just under 2.6%, prompting intensified inquiries from inflation-wary clients. In response to these questions, and in the context of the ongoing inflation debate, we have not only revisited some of the findings from our earlier work on global inflation, such as the effects of central bank liquidity, rising government debt levels, and ageing demographics, but we have also examined the effect that tightening labor market conditions and other potential shocks may have on inflation looking toward 2022.

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The prospect of a sharp pick-up in inflationary pressures is beginning to concern investors. Our historical analysis sheds light on how stocks, bonds and other asset classes behave during periods when inflation takes hold.

Inflation fears are rumbling through financial markets again. Unprecedented fiscal and monetary stimulus to contain the fallout from the Covid pandemic has investors worried that the multi-decade fall in inflationary pressures might finally be about to turn. The key question facing them is how to prepare.

In part, history suggests the outlook for markets depends on what the inflationary backdrop is likely to be. A combination of rising prices and modest economic growth, for example, favours commodities and gold. Inflation with an economy ‘running hot’, meanwhile, acts as a boost not only for those defensive investments, but also for real assets more generally – including housing, equities and high yield bonds.

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Countries that have experienced financial stress frequently lacked the amount of publicly available data that financially healthier nations readily provide. A reliable example is Argentina, which has defaulted nine times since the county was founded in 1816. Over a year before Argentina’s 2014 default, the International Monetary Fund (IMF) (2013) censured the country for not providing accurate data on inflation and economic growth. Yet, as early as Argentina’s first sovereign default in 1890, off-balance sheet government liabilities existed, which contributed to the default. In that seminal default, the issuance of commercial bank bonds had been permissioned so long as they were backed by government gold bonds. The financial innovation “constituted a new liability on the government’s balance sheet” (Mitchener & Weidenmier, 2008), one which exceeded more than £30 million. As context, Argentina’s 1890 default was £48 million in size. While a deterioration in the terms of trade and asset-liability duration mismatch were principal causes of the default, Ford (1956) noted that “he [the investor] was grossly misled by the Argentine government which because of its difficult budgetary position continued to borrow abroad merely to pay off existing service charges in the easiest immediate way”, suggesting transparency issues beset Argentina since its first sovereign default.

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The President’s proposal would add fuel to infrastructure themes in clean energy, data growth and an economic recovery, potentially strengthening an already attractive environment for listed infrastructure businesses.

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Over the past year, the COVID-19 pandemic has accelerated the shift to a new paradigm for economies and markets, characterized by near-zero interest rates, coordinated monetary and fiscal policy (Monetary Policy 3/MP3), and heightened internal and external conflict. While the pandemic was an accelerant, we believe a shift to this new paradigm was inevitable over time and that the key elements of this new environment will remain long after the virus passes.

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Head of Global Infrastructure, Ben Morton shares why we see the proposed spending package and tax changes as a clear positive for listed infrastructure.  He highlights how the stimulus ties into key themes we’ve highlighted over the past year in decarbonization, data growth and the transport recovery.

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