Opinions expressed whether in general or in both on the performance of individual investments and in a wider economic context represent the views of the contributor at the time of preparation.
This piece provides a brief discussion about inflation and how investors can seek to position for its impact.
The problem is well known: put simply, there is too much leverage and not enough growth in the world economy, with global imbalances exacerbating the issue. Much has been written about the subsequent risk of a ‘lost decade’ for many countries, a period of feeble real expansion as governments, consumers and financial institutions continue to deleverage. However, there are solutions at hand and one in particular stands out, namely the printing of more money, most likely via some form of enhanced quantitative easing. This approach is not without its critics and the by-product of potentially even looser monetary policy – inflation – has manifest and varied outcomes across the whole of the real economy. Understanding the impacts of inflation is a complex issue both for policymakers and investors. Below is our framework and, as a consequence, our investment approach for navigating through this period.
Inflation is conventionally defined as a rise in the general level of goods and services in an economy over time, measured by some form of consumer price index. This definition though is confused by several factors. First, inflation can occur in different forms (in assets, goods, services and wages), which can be interlinked, but are not mutually exclusive. It may vary on an industry-by-industry basis (and some companies might, for example, be able to find cost efficiencies elsewhere to offset inflation) and also across countries (although this issue can be complicated by trade flows and exchange rates). Inflation is also measured using different methodologies by different countries; these approaches are often regularly revised too. Moreover, from both an economic and an investment perspective, it is not just actual inflation (however measured), but also inflation expectations that can have an impact in influencing behaviour and decision-making.
On a consumer price index basis, inflation is already here. Data for the world’s thirteen largest economies highlight average year-on-year price growth of 3.2% (based on readings for October and November, published on Bloomberg), with the rate running at just under 5.0% in the UK and at an average of 3.0% across the European Union. In this context, it is worth remembering that both the Bank of England and the European Central Bank have targets to maintain price stability at a level of no more than 2%. With rates clearly well above these levels, both Central Banks appear to be sending a strong implicit signal that they are willing to tolerate above-target inflation (indeed, in the UK, inflation was last below 2% in 2009).
The corollary of this is that inflation expectations are also on the rise. The Bank of England’s most recent survey of such expectations (undertaken in August) show that participants anticipate a rate of 4.2% in twelve months’ time, still strongly above the Bank’s target. Expectations vary across the EU, but average 3.0%. In the US, the Federal Reserve also has some flexibility in its approach to inflation, given that it has a dual mandate to pursue both price stability and full employment.
If Central Banks appear willing to tolerate some inflation (and are also comfortable with this being built into expectations), the key subsequent challenges are threefold. First, what happens if inflation gets out of control; next, knowing when it has got out of control; and, finally, how to bring it back under control. Once the genie is out of the bottle, it is often hard to return it to its appropriate place. Historical precedents across numerous geographies and industries demonstrate the mutation of pockets of inflation in certain industries and geographies into a more malign form of sustained upward pricing pressure.
Sceptics of the more accommodative monetary route and its inflationary consequences are often inclined to highlight the hyperinflationary example of Weimar Germany. In 1923, prices doubled every two days and the inflation rate finally peaked at over three million percent (rates in Hungary in 1945-6 and Zimbabwe in 2004-5 nonetheless claim the records for the highest levels, both comfortably exceeding Weimar). However, historical precedents are of only limited value given the specific sets of circumstances that led to hyperinflation in each of the examples cited above. Moreover, with European unity currently being tested, inflationary outcomes across the continent that are above current levels may be preferable to a scenario of no growth and potentially more confrontational politics. In the US, the legacy of the Great Depression may also be a significant determining factor regarding future monetary policy.
On the positive side, inflation allows for implicit default, since debt burdens would shrink under a scenario of rising prices. Furthermore, the reduction in debt is achieved gradually, perhaps even surreptitiously. Inflation may also be helpful in reducing unemployment if it is enables labour markets to work more efficiently, with wages and prices adjusting to appropriate ‘clearing’ levels (lower real wages, if nominal wages are kept constant) in the absence of state intervention.
Conversely, with there being an erosion of the purchasing power of money accompanied by a loss in its real value, for every borrower that benefits, a lender (or those with cash) may suffer disproportionately. Workers may also demand higher wages, leading to price spirals and consumers may start to hoard goods out of concern that prices could rise further. Subsequent shortages (particularly of food) may also generate social unrest, as was the case both in Weimar Germany and more recently in the Arab Spring uprisings. More generally, under a scenario of (strongly) rising prices, it may be difficult for corporates and individuals to plan efficiently since uncertainty over future prices may discourage both investment and saving. This could damage future economic growth, but so too would any intervention to bring inflation back under control via, for example, higher interest rates or wage/ price controls.
Since the consequences of inflation across the real economy are not only lacking in uniformity but also highly ambiguous, investors are faced with a similar challenge in considering how to position portfolios for potentially higher prices. As mentioned earlier, timing is also crucial, since some inflation is probably both a necessary and a good thing for the global economy, but too much (with prices out of control) would clearly have a deleterious effect. Moreover, the transition from the first phase to the second, from benign to malign, is unlikely to be linear. When inflation (and future expectations thereof) becomes rampant, it will be swift, sudden and shocking for many.
In periods of weak economic growth (as is currently the case), inflation could help equities to outperform, subject to several caveats. Steadily rising inflation would drive positive equity returns, at least during its benign phase, as revenues would likely increase at a faster rate than costs, boosting margins and earnings. Furthermore, higher inflation would make bonds – as an alternative to equities – less attractive as an asset class.
The experience of UK equities in the period post 1974 and the Swedish market subsequent to 1988 are both encouraging in this respect, although these countries also benefited from two other supportive factors. First, equity valuations (on a ten-year Shiller-adjusted basis) were low when inflation first began to manifest itself meaningfully; and, there was healthy growth in earnings. Companies are able to deal with weak volume growth as long as nominal expansion remains healthy. This is especially the case given that academic analysis supports the contention that it is nominal GDP (in other words volumes combined with inflation) that is more closely aligned to corporate revenues than real GDP. Interestingly, in the case of Japan’s two ‘lost decades’ since 1990, neither of these factors has been present, and the Nikkei has derated by more than 75% since then.
Those companies that have typically performed best when inflation has started to rise (in a scenario where starting valuations are compelling and there is scope for organic earnings growth) are characterised by several factors, namely: they have pricing power, are effective at managing costs, capable of identifying new sources of demand and have the potential to de-equitise (allocate their capital effectively). ARM, Elekta, IBM, Linde, Mead Johnson, Pearson and Reckitt Benckiser are among the corporates that currently screen well on the majority of these measures. A number of these stocks are held in the Helicon Fund and by other managers on Heptagon’s platform.
Despite the evident quality of these businesses (and their potential to outperform across a number of different economic scenarios), equities do ultimately only protect against inflation to some extent. Analysis from Credit Suisse highlights that when inflation expectations start to rise significantly above 6% (and also if they fall below 1%), then equities tend to underperform. This phenomenon has been exhibited over a series of time periods and geographies.
Investors may, therefore, also wish to consider other asset classes in addition to positioning for (some) inflation via equities. Bonds, as mentioned earlier, are conventionally less attractive but US TIPS (Treasury Inflation Protected Securities) can provide some inflation protection, paying a yield that is indexed to some measure of inflation. In other words, real returns are effectively guaranteed over the life of the bond, irrespective on the rate of inflation in the interim. Such a strategy, of course, only works for as long as interest rates remain low.
Elsewhere, gold has its merits, being likely to outperform, again for as long as real interest rates remain negative. Moreover, it comprises a scarce asset which acts as a reliable store of value (timber would be another example). Finally, a number of equity and alternative asset managers adopt strategies that position them to mitigate a range of inflationary outcomes effectively. Absolute return strategies screen well in this respect as do systematic trading approaches via managed futures. This latter strategy has indeed delivered returns superior to other asset classes (equities, bonds and gold) over the last twenty-five years, a period of both strong inflation and subsequent deflation.
“Inflation is always and everywhere a monetary phenomenon,” wrote the economist Milton Friedman, and so if policymakers globally do resort to strategies such as more quantitative easing, then the consequence may well be higher prices. However, Friedman could also have asserted that it is a ‘complex phenomenon’ as highlighted above. Inflation can manifest itself in many forms, may likely progress in a non-uniform fashion and is probably only beneficial in achieving policymakers’ ends for as long as it remains benign and under control. Once the genie has been let out, it is much harder to put back in. There are no easy solutions, but positioning across a series of asset classes (particularly high quality equities) goes some way to establishing a defensible framework.
Alexander Gunz, Fund Manager, Heptagon Capital
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