Deutsche AM: stocks good with higher inflation

The December inflation figures for the Eurozone published last week have received much attention in Germany. Headline inflation was 1.1% for the Eurozone in comparison to the previous month. This was up 0.5% on the November level which was in keeping with our expectations. Meanwhile, inflation in Germany doubled to 1.6% (using figures from the German Statistical Office).

Much of the acceleration is driven by volatile elements, such as food and energy. But that is not the whole story. Over recent months there has been a substantial shift in inflationary expectations. They have increased considerably: The pricing of inflation swaps – meaning hedging transactions used by professional investors to hedge against inflation – demonstrates that market participants now anticipate average Eurozone inflation of 1.8 per cent over the next five years. Only a few months ago this figure was 1.2 per cent.

This means that investors are betting on the inflationary uptick spreading beyond energy costs and foodstuffs. And, as Europe’s largest economy, Germany will play a key role in determining whether they are right. Already, we saw German prices for services excluding rents rebound to 1.5% year on year in December, from 1% in November, the low point for the year.

For now, this is more of a public relations challenge than a real economic one for European policy makers, such as the ECB. Headline inflation figures will be boosted in coming months, simply because the oil price was a lot lower a year ago. For January we expect to see an inflation rate just below 2% in the Eurozone, assuming that crude oil prices remain stable. As the year progresses, that impact is likely to recede.

Meanwhile, the whole point of the ECB’s policy measures was to get inflation back up to close to 2 %. And, if parts of the common currency area are depressed with high unemployment, an inflation target would naturally imply that countries with strong economies and full employment, such as Germany, should be expected to overshoot.

But try to explain this to German voters in an election year. Politically, global influences will only make things harder. In the USA in particular, the pace of inflation increases is likely to rise if President-elect Donald Trump follows through on his pledge to massively increase spending on infrastructure and the military while also cutting taxes. In this case not only monetary policy, but at least in the medium term US fiscal policy, will have a positive impact. We have therefore already moderately increased our US inflation forecasts for 2017 from 1.6% to 1.9%. For the Eurozone, we assume inflation at 1.6% for full year 2017 in comparison to only 0.2% for 2016.

Even if stock exchanges are hovering close to record levels, gradually increasing inflation means investors are comparatively well placed with equities. This is particularly true for sectors and companies than can pass on price increases to their customers. We suggest infrastructure equities, such as those that profit from expansion of electricity or gas networks or indeed operators of toll highways. Dividend equities could also be worth considering in 2017 as Deutsche Asset Management forecasts dividends will account for 50 per cent of an equity’s total return. That is a record level. Having said that, both infrastructure and dividend papers tend to be vulnerable when bond rates increase strongly.