Preparing for inflation 2.0
My column ‘Preparing for inflation’ (13 March 2021) outlined why future asset allocation needed to reflect a changing investment landscape. Portfolio construction up to that point, indeed since first penning this monthly column in 2009, had been influenced by the view that interest rates were going to stay low for much longer than the consensus believed – the reasons were highlighted at the time. Columns since have touched on the importance of recognising higher and more volatile inflation is changing the investment dynamic, and the need for investors to adjust asset allocation accordingly. Four years on, and in all humility, it is perhaps time to revisit if not question our assumptions given their importance in guiding future portfolio returns.
A different juncture
Four years ago, investors had witnessed an extraordinary period during which governments for various reasons had kept interest rates artificially low. Perhaps the best example was the Bank of England’s policy given its remit to keep inflation at 2%. While the invasion of Ukraine is oft cited as an external shock nobody could rightly foresee, such a testimony ignores the fact that the month before the invasion interest rates were still only 0.5% while inflation was 5.5% and rising. In the Alice in Wonderland world of Quantitative Easing (QE), economic reality, policy responses and asset prices across the risk spectrum became distorted. This had portfolio repercussions, particularly regarding diversification.
We have now reached a different juncture. Talk of sluggish economic growth is contributing to the view that a series of interest rate cuts are on the cards. Investors should be wary. Just as markets were ‘blind-sided’ last year in expecting five to six cuts yet only receiving two, investors should expect further caution this year. Not only is stagflation a real possibility – the sluggish economic growth being fostered in large part by very high debt levels and the tendency of most governments to over-spend – but there are a range of factors fostering inflationary pressures to the extent higher inflation is now a central part of the investment equation.
Fast and slow burning pressures
Firstly, as is very evident today, geopolitical tensions have been rising for some time. The world order is being questioned as illustrated by Russia’s invasion of Georgia, the Crimea and Ukraine and China’s activities in the South China Sea. The nuances that often facilitated diplomacy are being replaced by hard alliances courtesy of which the middle ground and compromise stand less chance of succeeding. This itself is modestly inflationary – for example, commodities, including rare earth minerals, become more important pieces on the diplomatic chess board. Increased defence spending reinforces this pressure – wars, hot or cold, are usually inflationary and in some cases excessively so.
In tandem with this, there is also increased economic uncertainty. The threat of tariffs had predated President Trump – Biden had introduced a swathe of tariffs against China in retaliation to perceived ‘dumping’. But the current US administration is heightening uncertainty further by the way it is conducting negotiations – time will tell whether this is all about securing the deal. Higher tariffs are inflationary. The decline of globalisation is inflationary. Add in the need for more robust and shorter supply chains, courtesy first of lessons learned from the pandemic and then the deteriorating geopolitical outlook, which will add to costs, and increased prices look set to remain embedded for a while – there will be no quick fix to this.
There are further inflationary pressures building of varied influence and duration. The need for shortened supply lines comes at a time the West’s ageing population is gradually shrinking the available supply of labour. Not only is this resulting in fewer working people able to support societies’ humanitarian and financial obligations, but it is itself inflationary as higher wages will be needed to attempt to compensate for the labour shortage. The jury is out as to the extent Artificial Intelligence (AI) can help to compensate, but there are swathes of an economy where AI will simply not be able to do so by the very nature of the work. And whatever the outcome, evidence suggests disruptive technologies initially tend to be inflationary.
Then there are perhaps the elephants in the room – the scale of government debt and the Bond market. History suggests high debt makes for higher bond yields as markets seek compensation, and sometimes express concern at levels attained. The cost of servicing the UK Government’s debt has now risen to over £110 billion – a sum which exceeds the Defence budget, the Justice Department budget and half the Education budget combined. This cannot persist. Increased government spending, and the concurrent crowding out of the wealth-creating private sector, is a recipe for increased inflation. Once again, the evidence corrects those who doubt.
Other, somewhat more esoteric, causes of higher inflation are beginning to impact. Despite it being the right thing to do, the energy transition away from fossil fuels will add to costs and price pressures in part because of the scale of investment required. Space does not allow a closer examination of the figures, but large sums are needed. Meanwhile, the continued inadequacy of some (if not many) of the world’s financial institutions when it comes to economic forecasting and policy responses, together with the changing balance between capital and labour in favour of the latter, are further adding to cost pressures.
Portfolio construction
As such, we continue to believe higher and more volatile inflation is here to stay, and remains a key part of the investment equation. In recent years, these columns have referred to ‘three’ being the new ‘two’, and cost pressures continue to build. Perhaps the biggest impact relates to portfolio diversification. Once again, history suggests higher inflation and interest rates have tended to result in a more positive correlation between asset classes – making diversification more challenging. The reverse tends to be true in a lower-inflationary environment. This is one reason why our portfolios are overweight assets such as precious metals. More on portfolio construction in next month’s column.
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