Unintended Consequences?

By Salvatore J. Bruno, Chief Investment Officer and Managing Director, IndexIQ

Inflation, an (un)intended consequence?

We’re old enough to remember when $1 trillion was a lot of money.

These days, that number is tossed around pretty lightly, with the U.S. Treasury now planning to borrow about $3 trillion to support the economy during the coronavirus pandemic. Another trillion or so of spending has been proposed by House of Representatives Speaker Nancy Pelosi.  While deficit spending is clearly called for now, the longer-term impact of this level of borrowing on markets is unknown.

One thing we do know: there will almost certainly be some kind of unintended consequences. The unprecedented nature of the crisis and the magnitude of the resources being harnessed to combat it puts us well into uncharted territory and suggests that events will ultimately play out in unexpected ways.

The initial impact of COVID-19 has been heavily deflationary – millions of people out of work, companies forced into bankruptcy, yields on the 10-year treasury approaching zero – but that could change depending on the timing and the pace of the economic recovery. A rapid recovery in consumer demand coupled with massive fiscal stimulus could set the stage for broad-based price increases. As a thought experiment, investors may want to consider the potential impact that trillions of dollars in new government spending may lead to higher inflation levels over time.

For now, this is a somewhat contrarian point of view though it is gaining traction with a few market observers. A recent Bloomberg story quoted former International Monetary Fund Chief Economist Oliver Blanchard as saying that high inflation is “unlikely but not impossible.” (Bloomberg News Network: May 3, 2020) The argument goes something like this: the enormous fiscal and monetary stimulus being pumped into the economy is inherently inflationary; in spite of record unemployment there is actually some upward pressure on wages at the lower end as “essential workers” press for more compensation; disruptions in the global supply chain may lead to shortages in some areas, driving up prices; the repatriation of some essential production (if it happens) will locate it in higher-wage countries, increasing costs; and, finally, governments will find it tempting to inflate away some of these huge new debts they are assuming.

For now, we, too, view higher inflation as a low probability outcome, but the probability isn’t zero. Inflation can be highly destructive to wealth so it’s worth giving some thought to protecting your portfolio, just in case. Gold has traditionally been one storehouse of value, but our research has shown that there are other ways of hedging that may be more effective.  Multi-asset class products offer exposure to commodities (including gold), currencies, commodity-based equities, and even real estate with a goal of providing a “real return” – a return in excess of the prevailing rate of inflation.

It may seem a little strange to worry about inflation at the current moment. But good investors are always looking beyond the headlines. We have all been reminded again that events and markets sometimes move swiftly. Considering ways to mitigate a low probability but high impact outcome can be a prudent strategy.

The law of unintended consequences is front and center as we live through these challenging times. Now and then those consequences are meaningful. A reigniting of inflation would certainly be one of those times.