• Several factors appear to be stoking inflation fears. The Biden administration is pressing ahead with a US$1.9 trn package, just months after approval of a US$900 bln aid extension. Based on the plan, US$1,400 checks could be sent to roughly 85% of the US public while just 6.5% (net) have lost jobs. Thus, the bulk of the US$420 bln in checks could be outright macro stimulus rather than a “safety net” measure.
• The Federal Reserve has also moved to seek an inflation rate that averages at least 2% and expects to maintain a zero policy rate through 2023. This could see long-term forward inflation measures trend upwards.
• With extraordinary levels of spending by policymakers, the worries over inflation now are fueled by the abnormal imbalances of the pandemic. For example, there are large backlogs in goods orders while there is a huge slack in many services sectors which overall constitute 62% of US consumer spending. A return to equilibrium could generate temporary secular inflation. In short, there are distortions to the economy now that could see some price spikes in narrow categories. These could normalize with the reopening of the world economy.
• The resources policymakers have put behind fighting the COVID-19 crisis are dramatically larger and more forceful than any historic period. In Citi analysts’ view, this tilts inflation risks higher for the first time in decades.

Implications for portfolios

• For investors, most global bonds and cash are presently priced for negative future returns after inflation. These yields are deeply unattractive for portfolios. Prospects for economic recovery and the negative inflation-adjusted yield environment leaves Citi analysts preferring global equities over fixed income in asset allocation.
• However, within fixed income, Citi analysts favor selective segments which could help to achieve returns with reduced risk:
• Variable rate loans are preferred to high yield corporate bonds as they are higher in the capital structure and potentially offer less volatility without giving up on yield;
• Emerging Market (EM) bonds could benefit from firmer EM currencies and rising commodity prices which are likely in the New Economic Cycle. The asset class also offers higher yields relative to global bonds;
• Treasury Inflation Protected Securities (TIPS) are negatively correlated with risk assets and could also be a lower-risk beneficiary of higher trend inflation;
• US Mortgage REITs are among the highest-risk income vehicles, but still attractive in Citi analysts’ view, who hold a thematic overweight along with broader global equity REITs. Recovery from the pandemic could strengthen property fundamentals while the Fed is likely to maintain zero policy rates for far longer.