How do inflation and IT sectors correlate

The return of inflation?

  • The subject of inflation is once again playing a major role in the markets. In the current year, the inflation rates could well continue to rise due to special effects.
  • Against the background of underutilized capacities - particularly in the euro zone - we expect inflation rates below the central banks' target again in the next two or three years.
  • In the long term, however, demographic and structural changes should lead to increasing inflationary pressure.

The subject of inflation has returned with force on the capital markets: In the USA, inflation expectations have risen sharply since the beginning of the year and have driven returns ahead of them; At the beginning of the year, the eurozone recorded the strongest rise in the inflation rate since the common currency began.

A significant and sustained rise in inflation rates would sooner or later call the central banks into action. The prospect of rising money market rates in the long term alone has caused capital market rates to rise in the short term. Should this trend continue, further price losses on the bond markets would be the result. If there were then an overshoot on the interest side, so that not only the nominal interest rate rose, but also the real interest rate rose sharply, then the negative effects would not be limited to the bond market, but the stock market would also be affected - after all, play with the usual discounting of future profits real interest rates play a central role.

Which factors determine the development of inflation, which inflation rates are to be expected and how will this affect the capital markets - we want to pursue these questions in this CIO Special. For the answer, however, one has to think in different time horizons: In the short term, i.e. in the current year, numerous special factors could actually lead to an impressive increase in inflation rates. In the medium term, however, i.e. for the next two or three years, we assume that inflation rates will not rise too sharply because the underutilization of production capacities is likely to be considerable and unemployment is likely to remain substantial. This is neither an environment for wage increases nor one in which companies can raise prices significantly. In the longer term, i.e. viewed over a period of four, five or more years, a significant increase in inflationary pressure is quite conceivable because then the demographic tide should unfold its full effect and we do not expect the weak productivity growth to be sufficient, this demographic Compensate for headwinds.

The drivers of inflation worries

In January, the inflation rate in the euro zone showed the strongest increase since the introduction of the euro: from -0.3 percent in December to 0.9 percent; an increase of 1.2 percentage points. In the USA, too, the inflation rate has left its lows of last year far behind (Fig. 1).

Fig. 1: Inflation rates: significant increase

Sources: Haver Analytics Inc., DWS Investment GmbH; Status: March 2021

The worries about rising inflation rates are already manifesting themselves in the markets. In recent months, inflation expectations are[1] rose sharply. While inflation expectations in the US were around 1½ percent a year ago, they have now risen to just under 2½ percent. But even in the euro zone, where the European Central Bank (ECB) notoriously misses its inflation target of just under 2 percent, inflation expectations have risen from 0.75 percent a year ago to over 1.25 percent. However, caution should be exercised when interpreting this: the inflation expectations measured using inflation swaps are often not a good indicator of future inflation developments, but rather reflect current price developments (Fig. 2).

Fig. 2: Inflation expectations and oil price: high correlation

* measured on the 5 year / 5 year inflation swap.
Sources: Haver Analytics Inc., DWS Investment GmbH; Status: March 2021

Inflation expectations have risen sharply in recent months.

During the corona pandemic, the governments supported the economy with gigantic fiscal packages. Last year, for example, the USA took on debt amounting to around 17 percent of gross domestic product; in the euro zone it was around 8.5 percent. So that this enormous government spending does not directly lead to an undesirable deterioration in the financing conditions of companies and thus worsen the crisis, the central banks have flooded the markets with money and launched extensive (government) bond purchase programs. Last year, for example, the ECB extended its balance sheet by around 50 percent due to the PEPP (Pandemic Emergency Purchasing Program). At the Japanese Central Bank (BOJ) the increase was more than 20 percent and at the US Federal Reserve (Fed) it was over 75 percent. The combined total assets of the three major central banks rose by over 50 percent in the twelve months to January of this year (Fig. 3).

Fig. 3: Central bank balance sheets: rapid increase

Sources: Haver Analytics Inc., DWS Investment GmbH; Status: March 2021

However, a rise in the central bank balance sheet does not in itself lead to inflation. In order to be “price effective” at all, the money supply would first have to increase.

Econometric studies suggest that monetary stimuli are only reflected in the core inflation rate with a time lag of around one year.

The money supply (M3) in the euro zone has actually increased strongly - most recently by around 12.5 percent compared to the same month last year. But this is far less than the increase in the central bank balance sheet.[2] Growth of this magnitude would suggest a core inflation rate of around 2.5 percent. That would be far more than in the recent past, but compared to the aforementioned balance sheet increase of around 50 percent, it looks quite modest. In addition, econometric studies suggest that monetary stimuli are only reflected in the core inflation rate with a time lag of around one year (Fig. 4).

In the USA, the increase in the money supply (M2) was even more than 25 percent. As in the euro zone, however, this increase was essentially due to a one-time, strong expansion of the money supply at the beginning of the pandemic. Since then, the money supply has grown at fairly “normal” rates of around one percent per month in the US and around half as fast in the euro zone. For the USA, there is also the fact that the relationship between money supply growth and the inflation rate is far less pronounced than in the euro zone.

Fig. 4: Eurozone: money supply growth and core inflation - weak correlation

Sources: Haver Analytics Inc., DWS Investment GmbH; Status: March 2021.

Outlook on the development of inflation