Preparing for inflation

We live in interesting times. Just as there is a robust debate about the relative attractions of ‘value’ versus ‘growth’, there is also a related discussion as to the extent inflation will rise. While the portfolios will continue to focus on good entrepreneurial companies within their equity component, such issues influence portfolio construction when it comes to other asset classes. And unlike the daily machinations of market movements, inflation is influenced by government policies. Investors need to be aware of the agenda and positioned accordingly.

The backdrop

On the back of a global economic slump during the pandemic, the consensus was that deflation was the greater threat – the recovery would be patchy, unemployment would continue to rise, while the supply of goods and services would splutter back to life. The extent consumer spending bounces back once normality resumes is open to debate. However, there are counter-balancing forces are at work which suggest inflation is the greater threat.

In the Alice in Wonderland world of Quantitative Easing (QE), economic reality and asset prices get distorted. Modern Monetary Theory (MMT) now suggests governments can in essence fund spending at will by printing the required money. Yet governments have been pursuing MMT for some time. For all the talk of deficits being reduced, the debt kept rising and money kept being printed.

In part because of the pandemic, public debt across the developed world is eye-wateringly high – and rising. Policy makers are relaxed because borrowing costs are low – low gilt yields in part reflect substantial purchases by governments using their printed money. Meanwhile, given the extent of debt, it is in governments’ interest to keep interest rates low – artificially low. In combination, such policies better allow high borrowing and encourage inflation to help erode the debt over time. This has been the agenda for a while.

Since first penning this column in 2009, portfolio asset allocation reflected the view interest rates were going to stay low for much longer than the consensus imagined. The problem with the early rounds of QE is that the money printed was largely soaked up by the financial system to restore bank balance sheets crippled during the financial crisis. This time the money printing is reaching the front-line economy and beginning to affect prices. Encouraging inflation by way of low interest rates also has the benefit of concealing the true agenda in plain sight.

Expect to see more announcements such as President Biden’s near $2trn spending programme. Do not be surprised if the money supply figures are rising sharply – UK M4 and US M2 increasing 13% and 24% this past year alone. Or if pockets of inflation start appearing. But do not expect policymakers to react, as they once may have done, by raising interest rates quickly. The Federal Reserve has already indicated it is more relaxed about inflation passing through the 2% level, provided it averages around 2% over several years.

Other factors will contribute to inflation rising. Following the pandemic, business supply chains will be shortened. The ‘just in time’ model will be replaced with ‘just in case’ as greater emphasis will be placed on controlling production. Cash reserves will increase to better deal with any crises. This will also contribute to the sourcing of cheap labour becoming more difficult. This will adversely impact on profitability unless prices rise.

Add in the inadequacy of some of the global organisations, the deflationary force that is globalisation ‘stalling’, the new balance between capital and labour, an ageing population gradually shrinking the available supply of labour, and the trade war between the US and China, and one is also detecting long-term structural shifts in the inflation equation. In combination, rising inflation is now part of the investment equation.

Portfolio construction

How should portfolios be best positioned to produce real returns in such an environment? Experience suggests it wise to differentiate between the early stages of inflation (around 2.5-3.0%) and the higher levels thereafter. This is because markets can usually cope with modest and predictable swings when it comes to most data – it is what makes markets. But high and rising inflation is usually disruptive and creates greater uncertainty.

No one should be surprised bonds tend not to do well given they pay a fixed income. But government bonds in particular tend to do less well as inflation rises because the value of the mediocre income they do pay falls. Investors seek other inflation hedges. And while financial repression may affect this traditional relationship somewhat, it cannot indefinitely postpone it as inflation continues to rise.

During the early inflationary stage, higher-yielding corporate bonds offer better protection than gilts in part because higher inflation and economic growth reduce the risk of company defaults. Inflation-linked bonds have also traditionally acted as a good inflation hedge, regardless of the stage.

By contrast, equities usually embrace the early stage with vigour. Optimism is high, economic growth is improving and the inflationary genie is not yet out of the bottle. But inflation does not always usher in growth. Within their equity components, the portfolios’ focus will therefore continue to be on quality growth companies.

As highlighted in previous columns, given the extreme valuation differential between ‘growth’ and ‘value’, it will continue to be wise to reduce the extent of the portfolios’ overweight positions in growth – particularly if financial repression and negative interest rates lead to a sustainable and robust economic recovery.

However, it is worth noting that equities usually fail to produce real returns if inflation rises beyond the initial phase. This tends to be because investors are less willing to pay up for future earnings. In other words, the price/earnings (P/E) falls. Those companies on expensive multiples will perhaps be more vulnerable than most. This is another reason for increasing exposure to unloved sectors and markets, including the UK.

The portfolios also favour commercial property as inflation rises, particularly after the indiscriminate derating many quality companies endured during the pandemic. Although the ‘new working norm’ may have implications as to the balance of assets held, the well-managed companies should be able to pass on rising costs/rents to their tenants as economies recover – particularly during the early stage.

However, the portfolios’ key inflation hedges are commodities and gold. While both have traditionally produced strong real returns during the early inflationary stage, they really come into their own when it is apparent the inflationary genie is out of the bottle. The Commentary piece ‘The case for commodities’ (9 July 2020) explains why the sector is attractive – particularly the mining sector.

And despite the rise of Bitcoin, gold will also continue to produce attractive real returns, especially when inflation has entered its second stage – high and rising.

The portfolios’ infrastructure and environmental holdings should also help to produce real returns given prices charged by many of underlying investments are linked to inflation. This is especially the case regarding infrastructure which is why the sector tends to be the larger weighting of the two.

Falling energy price forecasts have resulted in some renewable energy companies cutting their inflation link. However, the fundamentals, including government carbon targets, sound managements and high sustainable company yields, still suggest optimism.

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