Inflation and the impact on financial markets

Inflation concerns have been on the rise and investors globally are seeing it as one of the biggest “tail risks” for markets over the next few years. Financial markets generally do not perform well when there is a sudden shift in inflation expectations.

For bonds, inflation may result in tighter monetary conditions including rising interest rates and less liquidity in the market. In the case of higher interest rates, fixed income instrument yields adjust upward, and prices move lower. This is because the interest payments from existing fixed-income assets become less competitive relative to newer, higher rate fixed-income instruments.

Less liquidity and bond-buying from central banks will also have a negative impact on bond prices.

For equities, potential tighter monetary conditions will also drag on prices. Higher interest rates erode company profitability because debt becomes more expensive to service. Consumer-facing companies have the added burden of reduced share of wallet because consumers are spending more money servicing debt, which can weigh on sales. Higher inflation may also result in fixed costs increasing; employees may demand higher salaries and general costs will increase, which will have an impact on operating margins. All the above will weigh on company earnings and therefore valuations.

As with bonds, less money in the system impacts on equity market volumes and demand for stocks which could impact valuations. As a second-order consequence, higher bond yields have a negative impact on equity valuations because the value of future cash flows from companies reduce when bond yields increase.

Of course, certain instruments benefit from higher interest rates, including variable rate cash instruments and interest rate-linked instruments like preference shares. Certain sectors in the equity market also benefit from inflation, such as consumer staples with pricing power, banks (if yield curves steepen) and utilities.

There are several reasons investors are stressed out about inflation, the main thrust being higher global growth expectations. Higher growth is a function of base impacts, fiscal spending, and the reopening of economies as the worldwide vaccination drive gains traction.

Inflation across the world

The US has been of particular interest because forecasts suggest that the US will breach the Federal Reserve’s (Fed) 2% target inflation level of inflation this year. Fears are that if this is sustained, it could force a response from the Fed. Fed tightening can have an impact on monetary policy and financial markets globally. And we have already seen inflation fears inducing bouts of volatility in bond and equity markets this year.

The Fed, however, has been consistently “dovish” in its communication. Its latest Federal Open Market Committee (FOMC) statement released last month indicated that even with strong economic growth numbers and higher inflation, it will need to see an improvement in broader measures of employment (labour force participation and wage growth) before considering a rate hike. The statement went on to say that the Fed views the current expected increase in inflation to be transitory. It also said that it will act on actual progress and numbers instead of forecasted progress and numbers. This means that it will be reactive in its approach rather than pre-emptive – an important signal to market participants.

The market, however, is pricing in four rate hikes to the end of 2023. The ultimate market reaction will be dictated by the Fed. If the Fed caves and tightens policy earlier than projected, the dollar will appreciate and risk assets could underperform. If the Fed is right, thereby supressing US real rates, the opposite plays out – the dollar will weaken and risk assets should do well.

Federal Target Rate

In emerging markets headline inflation remains well below five-year averages. As is the case in developed markets, we expect a short-term pickup in inflation on base effects, oil and commodity prices, and economies reopening. Medium term there are still very large output gaps, with high unemployment, weak fiscal policy and globalisation placing downward pressure on inflation.

In South Africa over the short term, headline inflation could breach 5% on the back of base effects, oil, and electricity prices. This should reverse before year end. The output gap in South Africa is still large, which should dampen inflation to some extent. We therefore expect policy rates to remain lower for longer locally as well.

Cyclical versus structural inflation

Forecasts already reflect a spike in inflation, but we propose that this is more of a cyclical phenomenon as opposed to structural.


Source: FNB Wealth and Investment, Fitch Solutions

There are some major structural factors that should keep inflation in check longer term:

·       Demographics: Lower birth rates and ageing populations are purported to be disinflationary. Aggregate demand declines since older populations tend to consume less, labour supply decreases, productivity levels decline and a sectoral shift in consumption patterns occur. We would anticipate these demographic changes to persist as more women enter employment and continued strides are made in healthcare.

·       Excess capacity: When actual economic output drops below its potential, it creates a negative output gap. Excess capacity in an economy is disinflationary. Output gaps globally are still quite high and, while we expect this to narrow in the US this year, it is likely to remain a deflationary force elsewhere in the world.

·       Technology – digitisation and automation: Technology reduces to cost of producing goods and providing services. These savings can be passed on to consumers. If they are not passed on to consumers, it could lead to competition entering the market that will place pressure on end prices as well. The information explosion has also increased pricing power of consumers over producers.

·       High levels of debt: We live in highly leveraged, high duration economies and highly leveraged financial markets. This means that even small increases in long-term interest rates will be enough to cause a major economic slowdown and ease any potentially building inflation tensions.


While investors are right to be concerned over current inflationary pressures globally, we believe that this is likely cyclical and that monetary policy responses will reflect this. There are structural factors that are keeping inflation in check. For now, it seems as if monetary policy will remain accommodative.

This is not to say that markets will not react to cyclical inflation fears from time to time. For now, however, it seems as if economic recovery will remain the priority for policymakers both at central bank and central government level.