Questioning inflation forecasts

Given the speed of events and economic news over recent months, this column returns to the issue of inflation and growth given the continuing disconnect between sentiment and fundamentals as to the outlook – policymakers underestimating the strength of the former, and the weakness of the latter. Relative to portfolio remit, such issues affect not just the extent and nature of exposure to other alternative asset classes, but also the equity strategies employed. Investors need to ensure their portfolios are positioned accordingly, and be prepared to take advantage of the opportunities created.

Plus ca change …

Despite recent economic headlines, in essence little has changed since suggesting early last year that the consensus view was wrong in believing disinflation was the greater danger – the column ‘Preparing for inflation’ (IC, 12 March 2021) highlighted the reasoning. Counter-balancing forces were already at work. In the Alice in Wonderland world of Quantitative Easing (QE) and artificially low interest rates, economic reality and asset prices were always going to be distorted. Despite talk of deficits being reduced, the money kept being printed and debt across the developed world kept rising.

Policy makers were relaxed because borrowing costs were low – low gilt yields in part reflected substantial purchases by governments using their printed money. Meanwhile, given the extent of debt, it was in governments’ interest to keep interest rates low. The combination of high debt and huge tax-and-spend agendas has contributed to economic growth being sparse by historical standards, living standards falling for the majority and inflation now being upon us with a vengeance.

Since first penning this column in 2009, portfolio construction reflected the view interest rates were staying low for longer than consensus forecasts – this accounted for the focus on ‘growth’ over ‘value’ within the portfolios’ equity exposure during the period in question. Early rounds of QE saw the money printed largely soaked up by the banks to restore balance sheets crippled during the financial crisis. The extension of QE well beyond its original remit always risked fuelling inflation as the money printed reached the front-line economy.

There can be little doubt that policymakers have certainly been negligent in not combating inflation earlier. Governments and central banks have ignored monetary growth figures going through the roof and clear evidence of pockets of inflation building. We were told inflation was not a problem. When it evidently was a problem, we were told it was going to be transitory. When this was evidently not the case, we were assured inflation would shortly subside. A pattern develops here which does not inspire confidence.

We are now at the point that policymakers are trying to play catch-up. The Fed has admitted there will be some pain as interest rates rise globally. Quantitative tightening (QT) has now replaced QE. However, policymakers are still suggesting inflation will decline to more normal levels over the coming years. The extent to which they may be talking their own shop is open to conjecture. There is little doubt central banks are restricted in their policy responses – to raise interest rates too aggressively would cause undue pain given the extent of debt levels allowed to accumulate.

The markets are conflicted. They too know there are few tools left in the toolbox. Yet elements are hoping the Fed will pivot away from rate rises so markets can recover, given the extent of debt and therefore prospect of economic pain. All debt has to be refinanced at some point. Others believe interest rates globally will continue rising in order to get ahead of the curve, to head off worse evils. A few know policy makers may well need to make the difficult choice between controlling inflation and financial stability. This heady cocktail helps to make for volatile markets as sentiment shifts between the scenarios.

The problem is compounded by poor and divergent economic forecasting – the difference in inflation forecasts between the Bank of England and the OBR is noteworthy. Yet policymakers are still underestimating the extent to which inflation will remain volatile and elevated relative to recent norms. There remains insufficient acknowledgement of the forces at work which, though incremental when viewed in isolation, are cumulatively moving the inflation dial while forecasters look away.

Rising geo-political tensions are ‘hardening’ alliances and the nuances that help facilitate understanding. In part accentuated by the pandemic, business supply chains are being disrupted and shortened as a result. The ‘just in time’ model is being replaced with ‘just in case’ as greater emphasis is being placed on controlling production. This will also contribute to the sourcing of cheap labour becoming more difficult. Increased costs will need to be either passed on or absorbed.

In parts of the world, more volatile weather including droughts, flooding, gales/tornados and heat-waves are increasingly threatening food production and disrupting economic activity. The situation is not helped by higher energy costs – a factor which may prevail for some time given an underinvestment in fossil fuels has created a gap in energy supply until further investment in renewable energy bridges the difference. Add in fertiliser shortages, and there should be little wonder that food and water shortages are on the rise. This begets higher prices and social unrest particularly where poor living standards prevail.

Competition changes over decades have led to a significant increase in mergers. For example, some estimates suggest the US now has only four major airlines, three major cereal-makers and two beer groups. Such a concentration of market power is not good for competition and consumer prices, while employees have also suffered as salaries have remained low given the lack of competition for labour. Such factors will assume greater importance as input costs rise.

We should also not underestimate the extent to which inflation can be much harder than expected to dislodge once it becomes entrenched in the system and human psyche. Hardened expectations get baked in. Believing that it will drop to more normal levels once current price increases fall out of the year-on-year comparisons is unduly optimistic. History suggests both in the UK and elsewhere that this rarely happens – the inflation tail remains pronounced

Meanwhile, because of an extended period of low interest rates, there are an increasing number of unviable ‘zombie’ companies – as many as 10% of US companies qualify. The process of ‘creative destruction’ has been impeded. This has resulted in a misallocation of capital to less productive causes. This, together with other impediments including the private sector being squeezed by high state spending/debt and falling living standards, has lowered productivity and economic growth. As people see the system struggle, they may be tempted to step out of the frying pan and into the fire by giving socialism a go.

Add in the inadequacy of some of our global organisations to properly tackle many of the world’s problems, the deflationary force that was once globalisation ‘stalling’, the new balance between capital and labour which is moving firmly in the latter’s direction, an ageing population gradually shrinking the available supply of labour, company cash reserves having to rise as a contingency (which will also adversely impact on profitability unless prices rise), and one is detecting medium-term structural shifts in the inflation (and perhaps growth) equation.

Portfolio consequences

Higher and more volatile inflation than recent norms has now become a central part of the investment equation. But for the reasons highlighted above, economic growth may be harder to find than policymakers would like – much harder without a cut in spending, greater efficiencies introduced and the market allowed to function properly. The prospect of stagflation (high inflation, low or no growth) looms. How should portfolios be positioned in this new era?

Valuations tend to move in long cycles. The bull market covering much of the 1980s and 1990s was marked by low inflation and deregulation. The bear market that preceded it from the mid-1960s was influenced by an era of stagflation during which equities tended to wait for earnings to catch up with valuations. If we are not to see a market correction, this looks the more likely of the two scenarios going forward. Of course, these long swings can unduly affect investor sentiment, which then in itself creates uncertainties and opportunities.

This suggests market volatility has further to run as interest rates continue to rise globally, liquidity recedes courtesy of quantitative tightening, and inflation remains higher than policymakers’ forecasts. This challenging environment requires a re-examination of the extent and nature of the alternative assets and type of equities employed. As suggested in previous columns, the traditional 60/40 equity/bond portfolio will probably struggle given it is typically using assets that are perhaps better suited to a previous market regime.

The implications are numerous. For example, equity investors will need to consider whether they have sufficient exposure to the long-term secular themes of the future and whether the correct balance between growth and value is being achieved, while remembering the importance of dividends and income to total returns. Those seeking diversification will need to recognise the correlation between most asset classes has increased, the importance of ensuring the alternative assets chosen have sufficient correlation to inflation, and the value of maintaining adequate levels of liquidity.

Yet despite the smoke and mirrors of volatile markets, investors should not become blind to the many opportunities which will surface in such an environment – as evident by the attractive discounts currently on offer within the investment trust sector. Correctly balancing those discounts and prospects against wider market conditions will be key to performance. Capitalising from the volatility is another reason to ensure sufficient cash resources.

These are considerations I will be returning to in future columns.

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