Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 412

How to invest as inflation fears fade

Last week, the US reported annual inflation of 5%, the highest since 2008. Pundits are suggesting investments in anything from commodities to value stocks will protect portfolios from rising inflation. My take is these assets have already run. But the current owners do need someone to sell to, which is why these stories abound. Current inflation is supply-chain based, temporary, and the recent price signals might even create the opposite effect.

Why is today’s inflation different from the 1970s?

The world has changed. The structure of today’s economy is radically different to the 1970s and 1980s.

1. Base effects 

Most of the inflation is either in the supply chain or comes from starting at a low base, both of which will pass.

Stimulus cheques do create inflation by boosting demand, but a one-period inflation spike does not create ongoing inflation.

2. Economic orthodoxy has been over engineered to prevent inflation

Stagflation was rampant in the 1970s and 1980s. The end came when central banks (led by the US) showed they were prepared to cause recessions to 'anchor' inflation expectations. Just as importantly, new rules were enacted to ensure inflation wouldn’t return:

  1. Monetary system: Independence from political intervention for central banks, inflation targets, various rules on government money printing.
  2. Oil prices: The best solution to high commodity prices is high commodity prices. A wave of investment and increased supply meant oil prices stopped rising.
  3. Deregulation: A range of industries changed from public to private ownership, lowering costs.

The pendulum has swung too far. The steps taken to prevent inflation have entrenched disinflation.

3. Inflation expectations

Low inflation expectations have become entrenched. Employees have stopped demanding continual wage rises. It took 30 years for expectations to fall from 5% to below 2%. A jump to higher inflation expectations is unlikely to be quick.

4. Changing economic structures and demographics

In most developed countries, manufacturing has shrunk as a proportion of the economy by a third since the 1980s. Union membership has plummeted. This puts even more focus on wages, as wages are the largest cost for service companies. The 1970s and 1980s saw significant financial reforms which dramatically increased debt levels. While debt is increasing, inflation increases, but high levels of debt are deflationary.

In addition, demographics are no longer delivering an economic tailwind, as shown below in the dependency ratio:

5. Technological innovation

In recent decades, the internet disintermediated entire industries, reducing costs, increasing competition and lowering inflation. Energy and automation will be the drivers for the 2020s.

China’s impact on commodity prices

China uses an incredible amount of commodities relative to its size. This is not a long-term phenomenon. It has arisen in the last 20 years:

The real culprit is the Chinese construction sector, far more than other infrastructure, and even railways are not as steel-intensive. The big consumer of steel is high-rise buildings.

Residential investment in China, as a proportion of GDP, is double the level of Japan before its housing crash and three times higher than the US before its housing crash.

Over the long term, we expect this to converge to more normal levels, particularly due to demographic headwinds.

What about US infrastructure? Won’t this increase commodity demand? CRU estimates $US1 trillion of US infrastructure will need about 6 million tons of steel and 110 tonnes of copper per year. Both are less than 0.3% of the current world annual supply. The net effect is that commodity inflation is far more leveraged to Chinese stimulus than developed market stimulus.

Again, on its own, this suggests a longer-term downside for commodity demand, but the overspend could last for years. The main reason we are concerned is that Chinese credit growth has come to a halt.

Several investment banks are pitching the story that investors need commodity exposure to protect from rising inflation. A weak Chinese construction market will blow that story out of the water.

There are both long-term and short-term reasons for the construction cycle to be peaking in China. Commodities are standing in the blast zone.

What is an inventory cycle?

The basis of most business cycles has an inventory cycle at the core. The stocking and de-stocking cycles are what typically drive economies both into recession and out of recession.

Assume we have:

  • A retailer who buys from a wholesaler
  • A wholesaler who buys from a manufacturer.

We are looking at the changes from period to period. For some companies, the periods are days. For others, the periods are weeks, months, or quarters. Both the retailer and the wholesaler target 1.5x the current period’s sales as inventory.

It looks like this:

Now let us look at the effect of a drop in demand. Say sales drop 10% for the retailer and then stay at the new level:

As you can see, the effect is more significant further down the supply chain. A 10% fall in sales for the retailer is a 60% fall for the manufacturer. In the initial stages of a recession, this effect worsens the cycle as manufacturers then fire staff and pull back spending. However, it works in the other direction as well. When the cycle turns, the opposite effect kicks in.

An extraordinary convergence = an inventory super cycle

Demand for goods has been temporarily boosted by:

  • Lack of other options as services like travel and recreation were shut.
  • Government stimulus, both direct and indirect.
  • Pent up demand as consumers who built up savings and are now spending.
  • A need for greater inventories from businesses to mitigate against future supply shocks.

Meanwhile, supply has been temporarily constrained by:

  • Lockdown constraints on workers.
  • Changes in demand. For example, more demand for houses, less for apartments. Manufacturers/suppliers need to change processes.
  • The Suez Canal blockage.

If we are in a super-cycle where demand increases and then returns to trend, it will be a wild ride for manufacturers. But inventory cycles are short. The price signals of today are building the excess capacity of tomorrow. The signs are good for economic growth but are not indicative of rampant inflation.

How to invest as inflation fears fade

The current rotation into value will not fare well if inflation fades. Indeed, it will be the worst place to invest as equity duration risk disappears for a time. There are three main options as to how the market treats the factor rotation changes:

  • Inflation falls back and lifts corporate profits, supporting ongoing high valuations, but 'value' gives way to mid-cycle 'quality'. In this scenario, investors should own longer duration bonds plus quality growth equities.
  • Inflation falls, yields collapse and stocks violently rotate back to the 'growth' stock bubble. In this scenario, longer duration bonds rise (yields fall) plus growth equities catch a bid. This is not for the faint of heart. If the non-profitable growth bubble re-inflates, it will be temporary. This scenario is best characterised as a tradeable bear market rally.
  • Central banks commit a policy error by following hawkish leads in China, New Zealand and Canada. The Fed tightens directly into the growth and inflation cliff ahead (even discussion of a taper will be enough). This will deliver a growth shock to markets alongside the deflation shock. It will force yields higher briefly before equities tumble. The entire reflation trade could collapse until the Fed reverses course. In this third scenario, a larger allocation of longer-duration bonds is the key. Equity allocations should be cut and repositioned like scenarios one or two.

The three scenarios represent an investment horizon of 12-18 months as the inventory super-cycle and commodities bubble deflate owing to a combined Chinese and US growth air pocket that ends the great stimulus and global reopening boom.

From there, we will still have low unemployment in the US with a large Biden stimulus lifting US growth towards 3% per annum for years. This holds out the real prospect for better wage gains and a grind higher for inflation through the cycle.

 

Damien Klassen is Head of Investments at Nucleus Wealth. This article is general information and does not consider the circumstances of any investor.

 

4 Comments
Doug Turek
August 02, 2021

"new rules were enacted to ensure inflation wouldn’t return: .... Monetary system: Independence from political intervention for central banks, inflation targets, various rules on government money printing"

From what I can see Central Banks are much less independent. They are trapped by their own policies and politicians who have discovered MMT to satisfy an electorate who has no interest voting for anyone promising less spending and not dealing with wealth inequality, climate change, ...

While it is interesting to speculate on will inflation persist or not, I think it is a distraction to try to predict. Inflation surprises by definition and history. More important is to invest assuming inflation does arise and be happy if it doesn't. Inflation is the #1 enemy to retirement portfolio longevity, not deflation.

Ruth
June 24, 2021

Some interesting thoughts there Damien, thank you. I just can't get it out of my head that even though we have a lot of deflationary forces out there, that we will see inflation, not because goods/services etc are going up, but because the currency we pay with must be going down as they are valued relative to each other. I hope Australia avoids that by not creating too much fake money. But I can't see how the USA can avoid it in the long term.

Michael2
June 19, 2021

When I first bought online postage was free. Now I pay postage on almost everything

Gary M
June 16, 2021

I'm really struggling on this inflation business ... on the one side, I see higher prices everywhere, and I don't think the barber who charged me $20 last year and now charges $25 is ever going back. Shortages of labour everywhere, commodities higher. But then it's all supposed to settle back soon with technology driving down costs.

 

Leave a Comment:

RELATED ARTICLES

The coiled spring: markets are primed for the year ahead

Reality bites

Is 'The Great Australian Dream' a sham?

banner

Most viewed in recent weeks

Raising the GST to 15%

Treasurer Jim Chalmers aims to tackle tax reform but faces challenges. Previous reviews struggled due to political sensitivities, highlighting the need for comprehensive and politically feasible change.

Here's what should replace the $3 million super tax

With Div. 296 looming, is there a smarter way to tax superannuation? This proposes a fairer, income-linked alternative that respects compounding, ensures predictability, and avoids taxing unrealised capital gains. 

100 Aussies: seven charts on who earns, pays, and owns

The Labor government is talking up tax reform to lift Australia’s ailing economic growth. Before any changes are made, it’s important to know who pays tax, who owns assets, and how much people have in their super for retirement.

The rubbery numbers behind super tax concessions

In selling the super tax, Labor has repeated Treasury claims of there being $50 billion in super tax concessions annually, mostly flowing to high-income earners. This figure is vastly overstated.

9 winning investment strategies

There are many ways to invest in stocks, but some strategies are more effective than others. Here are nine tried and tested investment approaches - choosing one of these can improve your chances of reaching your financial goals.

With markets near record highs, here's what you should do with your portfolio

Markets have weathered geopolitical turmoil, hitting near record highs. Investors face tough decisions on valuations, asset concentration, and strategic portfolio rebalancing for risk control and future returns.

Latest Updates

Investment strategies

Finding income in an income-starved world

With term deposit rates falling, bonds holding up but with risks attached, and stocks yielding comparatively paltry sums, finding decent income is becoming harder. Here’s a guide to the best places to hunt for yield.

Economy

Fearful politicians put finances at risk

A tearful Treasury chief, a backbench rebellion, and crashing bonds. What just happened in the UK and why could Australia’s NDIS be headed for the same brutal fiscal reality?

Shares

Investing at market peaks: The surprising truth

Many investors are hesitant to buy into a market that feels like it’s already climbed too far, too fast. But what does nearly a century of market history suggest about investing at peaks?

Shares

Chinese steel - building a Sydney Harbour Bridge every 10 minutes

China's steel production, equivalent to building one Sydney Harbour Bridge every 10 minutes, has driven Australia's economic growth. With China's slowdown, what does this mean for Australia's economy and investments?

Investment strategies

Will stablecoins change the way we pay for things?

Stablecoins have been hyped as a gamechanger for the payments industry. But while they could find success in certain niches, a broader upheaval of Visa and Mastercard's payments dominance looks unlikely.

Infrastructure

An investing theme you can bet on for the next 30 years

Investors view infrastructure as a defensive asset class rather than one with compelling growth prospects. These five tailwinds for demand over the coming decades suggest that such a stance could be mistaken.

Investment strategies

A letter to my younger self: investing through today's chaos

We are trading through one of history's most confounding market environments. One day, financial headlines warn of doomsday scenarios. The next, they celebrate a new golden age. How can investors keep a clear head?

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.