After governments and central banks announced unprecedented monetary and fiscal stimulus to fight the Covid-19 crisis, some investors have been sounding alarm bells over fears of inflation.
Despite the warnings, financial markets are pricing in deflation, and fund managers mostly agree that that is the more pressing risk.
However, Ivan Kralj – assistant fund manager of the Jupiter Absolute Return fund –said in a recent note to investors, that policymakers around the world are increasingly risking destabilising the global monetary system.
“Most countries have unfortunately entered the crisis with too much debt, and given there is little political appetite for the bankruptcies that could rid the system of that debt, the only other option to reduce it is to inflate it away,” he said.
“History shows that the direct monetisation of government debt eventually leads to runaway inflation and potentially unlimited debasement of paper currencies’ value.
“Many point out that QE [quantitative easing] did not result in inflation a decade ago, so why should it now? The difference is that all the liquidity largely remained trapped in the banking system and did not flow into the real economy.”
Kralj said that this time, ‘the biggest fiscal and monetary stimulus in history’, is targeting lower-income individuals and small businesses, which tend to exhibit a much higher velocity of money than large institutions.
The Jupiter fund manager said this will have a much stronger inflationary impulse, and in combination with the disruption and deglobalisation of supply chains, could create strong inflationary pressures.
Although he concedes, “Ultimately, most asset classes are pricing in a deflationary shock, and few investors and capital allocators are worried about inflation today”.
Inflation (CPI)
Source: OECD
Consumer price index (CPI) measures globally are being pushed downwards – as the above chart shows – amid a backdrop of collapsing oil prices and falling producer prices, reflecting the dramatic drop in export and domestic demand caused by the crisis.
Talib Sheikh, head of strategy – multi-asset at Jupiter Asset Management, said central banks will allow inflation to ‘overshoot’ as they keep rates close to or below zero and continue expansionary fiscal policy to boost the economy post-crisis.
“Governments will be strongly incentivised to get inflation higher after this crisis, both to reduce debt burdens and stimulate economies,” he said.
David Jane, multi-asset fund manager at Premier Miton Investors, agreed, saying that the economic shock of the pandemic was hugely deflationary and as such was what markets are currently pricing in.
“It is easy to suggest that free money from governments, with no production to support it, is inflationary,” he said. “Everybody spending and nobody making anything is obviously inflationary. The reality is, however, much more complex.
“We have lower energy costs; changing medium-term consumer preferences; disrupted supply chains; mass unemployment; distressed businesses discounting products, all working in different directions.”
He said the balance of these competing factors was ‘hard to fathom’.
Jane said there is likely to be an inflationary impact of new health and safety measures, which would inevitably lead to reduced productivity and increased business costs. 
However, given the demand shock, and the number of jobs that have been lost, long-term demand is unclear.
“Depending on how long industries take to recover this would be deflationary,” he said. “In the short term, the governments are paying over 15 per cent of the workforce not to produce anything and supporting business owners to stay closed. This is evidently an inflationary force, other things being equal.
“At the same time, there has also been a supply shock, firstly during the lockdown as nothing has been made, with factories and services businesses on lockdown.”
In addition, long-term supply chains have been disrupted “to a degree we do not yet have visibility of”.
“At present things are clearly very deflationary, but the outlook, post a return to work, is much less clear, Jane added.
The Premier Miton manager said many of the changes to consumer and business behaviours will be costly and that “therefore the assumption would be inflation increases over time”.
But until there is evidence of inflation, Jane won’t be acting aggressively to hedge, but he favours gold and infrastructure assets as good inflation hedges.
Andrew Wilson, head of global fixed income at Goldman Sachs Asset Management, is also not too concerned about inflation in the near term, and said that neither is the market worrying about it.
“We think that we are in a world where official rates stay low for long, maybe forever in terms of the investment horizon,” he explained.
“The implication is that as activity picks up, potentially inflation emerges, and I think that’s two-to-three years away.
“Central banks will be tolerating higher inflation rates, willing to see them drift up before they tighten policy in any shape, way or form.”
Wilson did say, however, that the technicalities of measuring inflation will be difficult, as the basket of what we’re consuming will change and be very different.
The fixed income specialist said it might be a little too early to position for inflation given the uncertainty of the outlook.
“There’s going to be extremely deflationary impacts, one-to-two years with central banks continuing to struggle with inflation,” he concluded.
“Pushing it out two-to-three years, if we have a very effective vaccine and we see a real pick-up in activity, central banks have a lot of tools and can unwind QE and raise interest rates by a large amount.”
However, Wilson said he sees this as more of a tail risk.