Inflation proving stickier than originally thought

Inflation, driven by government spending, strong consumer demand and a bottle-necked supply chain, will likely persist for at least the next six months, says Hadiza Djataou, vice-president and senior investment director with Mackenzie Investments’ fixed-income team.

Add new uncertainty around the omicron Covid-19 variant, and consumer prices, rents and wages are unlikely to drop anytime soon.

“Inflation is going to be stubborn and is going to stick around for at least until the middle of next year,” she said. “We’re going to have to face a stickier inflation than we expected only a few months ago.”

Djataou said imbalances between demand and supply have wreaked havoc in some sectors, among them the auto industry where a shortage of computer chips has created a backlog of unfinished cars.

“With the emergence of omicron, we could even see additional supply bottlenecks in the economy, especially in North America,” she said, adding that investors — particularly bond investors — are increasingly seeking protection from inflation.

“There are areas of the market where you can have a fluctuating coupon, and you can also receive an income that is more related to inflation, and therefore you don’t see your purchasing power being eroded,” she said.

For example, U.S. Treasury inflation-protected securities (TIPS) have become popular in recent months as a hedge against rising prices, but that popularity could dilute their performance next year, Djataou warned.

“TIPS have been the favoured instruments to play inflation by direct investors,” she said, “but there’s a form of speculation running TIPS today. So that’s why the outlook is not necessarily negative, but there’s mostly going to be volatility around their price going into 2022.”

Djataou said alternative fixed-income products like TIPS have joined traditional bonds on the “40” side of the 60/40 recommended investment split. She said “the new 40” takes into account the fact that equities have long outperformed fixed income. Extending the fixed-income spectrum is an attempt to keep investments in balance.

“The new 40 would [include] a somewhat differentiated type of assets where you will receive a flexible income — an income that will reflect ongoing market condition,” she said.

As for other fixed-income strategies, she is underweight government bonds because of the threat of rising interest rates going into 2022. She said the market is pricing in a rate hike, but not to a sufficient degree.

“On the other side of the spectrum, we love corporate debt and we’ve been expressing our active risk positioning in leveraging high yield, and also in investment grade,” she said. “One of the key strengths of our team is to play that corporate space in public debt markets [and] also on private debt, where we’ve been adding some significant exposure throughout 2022.”

Djataou said the jury is still out on the effectiveness of cryptocurrencies as an indirect hedge against inflation. Any evidence that it functions in that capacity could merely be “a self-fulfilling prophecy,” she warned.

“If the market collectively believes that Bitcoin is going to protect them from inflation – which they believe today — well, there is a strong correlation when inflation expectation is rising, we see Bitcoin price rising again.”

Djataou said direct inflation hedges like commodities have performed well, particularly gold and lumber.

“All those commodity prices have been rising significantly and they’ve actually been feeding into headline inflation,” she said.

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This article is part of the Soundbites program, sponsored by Canada Life. The article was written without sponsor input.