Publish by Bowmore Asset Management, May 2021
As the vaccine rollout across the world accelerates, signs that the global economic recovery is also gathering momentum has boosted confidence. With confidence and growth comes the probability of inflation, particularly when interest rates around the world are languishing at record lows. Central banks have pumped unprecedented levels of stimulus into the global economy, which also helps to increase the chances that inflation will rise. Mounting inflationary pressure causes the erosion of capital in real terms and should be a warning to all in investors in low yielding assets. This month we explore ways to combat such rising prices.
Inflation can be both good and bad. “Cost push” inflation sees rising prices as a result of input prices increasing. A good example being oil prices feeding through into higher cost of consumer products – petrol for instance. This type of inflation is deemed negative as consumers and businesses pay more, even at times when they can’t afford to do so. On the other hand, prices rising as a result of increasing demand is deemed positive – called “demand pull” inflation. Typically, this is a direct result of growing confidence, increasing global growth and therefore consumers becoming wealthier and becoming more willing and able to spend. Both types result in rising prices, but one is far more beneficial than the other.
Inflation erodes the value of money. As prices rise, £1 today buys you less in the future. Whilst in any given year a 2% (say) rise in prices will not have much impact, consistently compounding 2% price rises can have a crippling effect on savings and any investments not earning the same as or more than the rate of inflation. After 10 years, with 2% inflation each year the value of £1 falls to 79p, 3% inflation makes £1 worth 65p and 4% inflation makes £1 worth only 52p. Such dramatic erosion of capital cannot be ignored.
Since 2015 inflation had been starting to trend higher but during 2020, COVID-19 derailed inflation entirely, with UK inflation falling from just under 2% to 0.4% due to the pandemic:
However, due to massive central bank stimulus and now dwindling COVID cases in Europe and the US, prices are rising again, and UK CPI currently sits at 0.7%. Whilst significantly below the Bank of England target inflation rate of 2%, it is the direction of travel that is most important, and seemingly, inflation is on the rise.
The same is true in the US, where the Federal Reserve (Fed) announced expectations in March that US growth will top 6.5% this year. Fed officials also expect above trend growth of 3.3% in 2022 and 2.2% in 2023, against a longer-term average of 1.8% expected. As a result, the Fed expects inflation to rise to 2.4% this year, way ahead of the 2% target. They have, however, pledged to disregard this target, and if not careful this could fuel further inflation. It’s a very dangerous game to play because inflation is a lagging indicator, meaning that you won’t see the data to prove that prices have risen until after the event. Leaving it too long to hike rates runs the risk of out of control inflation, meaning more draconian rate rises further down the line and markets hate the prospect of unpredictable interest rates. We hope that the Fed’s decision to effectively support lower rates for longer doesn’t come back to bite them, and us, in the future.
Inflation – it’s what everyone is talking about:
One of the drivers of stronger economic growth this year is expected to be a significant pick-up in consumer spending as lockdowns are eased and those that have been able to save during the pandemic look to splash the cash. It is estimated that household savings in the U.S. are about $1.5 trillion larger than the savings generated in the year before the pandemic – equal to about 7% of 2019 GDP:
Much of this is “forced” saving, with many households unable to spend the same proportion of their income as they have in the past due to lockdown. These “forced” savings will start to be spent as restrictions ease, as post COVID queues outside high street shops suggest.
China provides us with an example of just how this pent-up demand could be released. Services output in China has almost returned to its pre-pandemic trend just three quarters after the virus has been brought under control. Domestic air travel in China is now almost back at pre-COVID levels:
So, what is the best way to protect against inflation? Schroders studied asset price returns all the way back to 1973 and split the results into four sections. Equities, commodities and commercial property are regular outperformers when inflation rises slowly (although with the landscape for property shifting structurally as a result of COVID, the jury is currently out on the prospects for bricks and mortar). However, to benefit investors, the conditions for inflation need to be just right because when inflation rises by more than 3% per annum, seemingly US equities only beat inflation 48% of the time, whilst commercial property and commodities still perform well.
Probability (%) that various asset classes will beat inflation under one of four scenarios (green is good, red is bad!):
Therefore, inflation can be good to a point, but runaway inflation is bad news and this is all the more reason to be hopeful that the Fed have got their ‘lower for longer’ interest rate strategy right.
Fixed interest is the one asset class that suffers more than any when inflation is rising, because the fear is that central banks will increase interest rates to combat rising prices, and this is bad news for bonds. US Treasuries underperform when inflation rises but bear in mind that bonds are the only asset class that serve the role of hedging against any shocks to the system which might derail global growth. COVID is a good example of one such continuing risk. What about inflation linked bonds? Surely these investments will protect against rising inflation. Ordinarily they would, but prices of index-linked bonds are at a point now where buying will guarantee a loss of capital unless inflation spikes way above what is expected.
Returning to the current environment of slowly rising inflation, equities and commodities seem best placed to benefit. Yet not all sectors of the equity market perform well in periods of rising inflation. Those that do well include financials, energy and consumer staples. Banks do well because higher inflation will usually mean higher interest rates and banks make greater margins when rates rise. Energy companies pass on rising input prices to consumers justifiably and consumer staples perform well because households are reluctant or unable to cut consumption of key goods such as food, beverages and hygiene products. These sectors can be considered “Value” rather “Growth” investments and perform better when inflation rises.
On the other hand, sectors such as technology can perform poorly during periods of rising inflation because investors buying these companies are paying high prices now for earnings far in the future. Inflation erodes the value of those future earnings and this makes technology companies and other growth sectors even more expensive now.
We believe that inflation will be a major theme for the next few years, and investors should plan accordingly. Higher inflation is usually a precursor for rising interest rates and whilst not inevitable, it is now more likely than ever that rates will rise, although perhaps not for 18 months or longer, if the Fed and Bank of England are to be believed. Remaining underweight bonds and “bond proxies” such as utilities seems sensible and increasing exposure to commodities should help combat rising prices. Maintaining ownership in equities and tilting the balance of investments more towards steady, stable businesses with good cash-flow generation today (some “Value” investments) will also benefit and considering lower exposure to technology and other high growth sectors may prove prudent if high inflation persists. Finally, whilst it is always preferable to have some cash as a buffer, large cash deposits will continue to prove hard to justify whilst interest rates are so low.
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