Shifting dials

The dial is shifting across a range of issues. These include Russia’s invasion of Ukraine and China’s more robust foreign policy shifting geo-political calculations, the pandemic crystallising more immediately a number of trends and priorities for both governments and peoples alike, and investors becoming aware that central banks have changed their tune and inflation is no longer ‘transitory’. The latter in particular has implications for investors not only in relation to the balance and nature of their portfolios’ diversification, but also the composition of their equity component. Investors need to be positioned accordingly as interest rates rise more than initially expected.

Higher inflation and interest rates

The column ‘Preparing for inflation’ (12 March 2021) outlined why persistently higher inflation was now part of the investment equation, in contrast to forecasts at the time, and how portfolios were being positioned accordingly. On the back of a global economic slump during the pandemic, the consensus was that deflation was the greater threat. However, there were and are counter-balancing forces are at work.

Reference in the piece was made to the Alice in Wonderland world of Quantitative Easing (QE) where economic reality and asset prices get distorted, and to our long-term contrarian view as to why governments had kept interest rates artificially low. Both policies had facilitated high borrowing and deficits, with central banks relaxed as to whether such policies would encourage moderate inflation given this would help erode the high debt levels over time – the prevailing belief being inflation could be tamed before it became a problem. Such policies also had the added advantage of concealing the true agenda in plain sight.

Accordingly, central banks have been ‘behind the curve’. Despite all the usual precursors to higher inflation flashing red at the time (for example, the UK M4 and US M2 money supply figures) and clear evidence of pockets of meaningful inflation, policymakers did not react as they once would have done by raising interest rates quickly. The Federal Reserve indicated at the time that it was more relaxed about inflation rising above 2%, given forecasts that inflation was not a problem. One is again reminded of Galbraith’s quip that the only purpose of forecasting is to make astrology look respectable.

This has now all changed. The inflationary ‘genie’ is out of the bottle. The problem with the early rounds of QE was 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 has been reaching the front-line economy and affecting prices, and central banks have become alarmed at the level of expected inflation. There is no more talk of inflation being ‘transitory’.

In addition to QE being replaced by Quantitative Tightening (QT), the Federal Reserve and markets are now factoring in an increased number of interest rate rises – some estimates suggesting UK rates will reach around 2.5% by the end of the year. The concern for the markets is one of recession or very possibly ‘stagflation’ – high inflation and low/no economic growth. The portents are ominous. Of the 16 tightening cycles since the 1970s, certainly 12 have ended in recession.

And any market equivocation about the issue will come to better recognise the other long-term structural factors affecting inflation – some of which have been reinforced of late. Geo-political risk is seldom absent as the trade war and rhetoric between the US and China has reminded us, but the invasion of Ukraine marks the coming of a new Cold War in the defence of democracy – something we have previously thought required little investment. The West is once again waking up to the fact that the concept is fragile – it needs nurturing and protecting – for there are many who do not value it. Hard and soft power budgets are going to increase.

The resulting hardening of alliances, together with the lessons from the pandemic, is contributing to business and energy supply chains being shortened. The ‘just in time’ model is gradually being replaced with a ‘just in case’ approach. Corporate cash reserves will increase to accommodate any crises. This will also make the sourcing of cheap labour more difficult. Indeed, wage inflation will be a key factor in this new inflationary landscape, also encouraged by the shortage of workers courtesy of demographics and an understandable political agenda to better support the lower paid. This will all adversely impact on profitability unless prices rise.

In combination, such factors will result in persistently higher inflation almost regardless of the economic backdrop. Markets are re-adjusting to this new environment. Portfolios need to be suitably constructed, relative to their remit.

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