Updated 26 Nov 2020
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This is a non-independent marketing communication commissioned by BlackRock. The report has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is not subject to any prohibition on the dealing ahead of the dissemination of investment research.

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For the past decade, investors haven’t had to fear inflation. Long-term deflationary forces, such as the rise of China, an ageing population and high debt have conspired to keep inflation below central bank targets. However, for the first time in a number of years, investors may need to pay attention to rising prices.

Inflation can have a disastrous impact on long-term wealth. £100,000 invested in the year 2000 would need to have grown to £177,000 today to have the same purchasing power1. That is through a period of relatively benign inflation; inflation running closer to 3-4% could have a far more corrosive effect on investors’ long-term savings.

Why is this more likely today? Perhaps the most important factor is the fiscal stimulus packages launched in response to the pandemic. While loose monetary policy pushed more liquidity into the financial system, fiscal policy puts money directly into the hands of UK consumers. While job losses and economic disruption from the pandemic is keeping a lid on inflation in the short term, it may become a more significant problem in the longer term, particularly if a vaccine is found and life returns to some kind of normality.

There are other drivers for higher inflation. In recent years, inflation has been kept relatively low by the influx of cheap goods from China. This had already started to shift as the US and other countries sought to address their vast balance of payments deficits with China. This ‘re-shoring’ trend gathered pace with the COVID-19 crisis as companies started to realise the fragility of some of their supply chains.

There are already signs of ‘deglobalisation’ and the remapping of supply chains for greater resilience against a range of potential shocks. However, this could increase costs and – by extension – inflation. Bringing production onshore could give domestic workers more bargaining power on wages, particularly in places where the political pendulum is swinging toward addressing inequality.

Central bank changes

We also see a change of heart from some central banks, who are becoming more tolerant of inflation overshooting stated targets. The Federal Reserve recently changed its policy framework, saying it would need to see inflation sustainably ahead of its targets to move on interest rates. Inflation is not always easy to contain once it takes hold and, as such, this new attitude from central banks may see inflation move structurally higher.

There is also likely to be political pressure to keep rates low. Consumers have grown used to low mortgage rates and cheap credit. In the wake of the pandemic, unemployment levels will be higher. Any decision by central banks to raise rates could be politically charged and may come under fire.

Mining and inflation

Mining companies have traditionally been seen as a defence against higher inflation – with good reason. Inflation tends to increase at times of higher global demand. When the economy is doing well and new things are being made, demand grows for energy and mined resources, pushing up prices.

A recent paper from Morgan Stanley found that this correlation held up well under scrutiny. It identified 11 periods since 1998 when inflation expectations were ‘sharply rising’2. This was defined as periods with more than 39bps quarter on quarter increase in 10Y Treasury Inflation-Protected Security (TIPS) breakeven inflation.

Mined commodity prices performed strongly on average during these 11 periods over 6, 12 and 24 months. Unlike equities and bonds, commodity prices tend to be positively correlated with inflation expectations. Mining equities performed very strongly on an absolute basis and relative to broader equity markets on average in these 11 periods3.

Can this continue?

We believe this part of the market could provide protection against inflation in this cycle as well. One of the major policy responses to the pandemic has been to mandate vast infrastructure building: as part of China’s attempts to stimulate its economy in the COVID-19 crisis, it has issued over USD $500 billion in special bonds to be spent on infrastructure3. This includes investment in buildings, roads, airports and railways, which tends to be resource intensive.

At the same time, the US President-elect Joe Biden is in favour of ramping infrastructure investment, with his announcement of a USD $2 trillion renewable energy investment plan during his campaign. There has also been vast investment promised into the transition to a low carbon economy4. The EU, for example, has committed €1 trillion as part of its ‘Green Deal’5. This is also likely to create demand for mined resources.

This creates a solid backdrop for companies to grow their earnings and the dividends they pay to shareholders. This should in turn help investor portfolios keep pace with inflation. We believe investors cannot neglect the risk of inflation in this environment and energy and resources may be able to provide some protection.

This material is not intended to be relied upon as a forecast, research or investment advice, and is not a recommendation, offer or solicitation to buy or sell any securities or financial product or to adopt any investment strategy. The opinions expressed are as of October 2020 and may change as subsequent conditions vary.

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