Punter Southall Wealth
What might tomorrow bring? Inflation in the 2020s
The world outside looks a bit grey and dreary from the windows of our home offices. As we know, the virus has wrought havoc and pain across society and in turn, triggered a wave of stimulus from central banks and governments around the world in quantities the likes of which we’ve never seen. Financial markets have been huge beneficiaries here, with certain sectors (Technology) and styles (Growth) doing fantastically well as the “digital transformation” and waves of central bank asset purchases (Quantitative Easing “QE”: a central bank replacing less-liquid assets with liquid cash, freeing up money to stimulate the economy) have driven up prices. Granted, there will be setbacks on the path to recovery, but recovery will eventually come. The sun will shine again, economies will re-open and a life more normal will resume. As many industries struggle to find their feet again, it is likely that governments will help them get up “off the canvas” and also look to support new infrastructure and cleaner, more sustainable technologies in an effort to “Build Back Better”. Our view is that this could lead to structurally higher inflation later on this decade and is something we believe investors should be proactive in protecting themselves against.
The last decade in financial markets have been typified by low growth and fears of deflation, with the various QE methods by Central Bankers being largely ineffectual. To a large extent this was exacerbated last year. With the vast majority of the world locked down at home, there was very little that anyone could spend their money on, as a result demand fell and economic growth halted, creating a deflationary backdrop. This benefited long-duration assets such as government bonds and growth equity companies who are expected to keep growing their profits into the future: a clear winner for Technology.
It is our belief that inflation is set for a substantial rise in the middle part of this year, but will then likely drop back down and not rear its head again for another couple of years. This is a matter of simple mathematics: namely, the increase in demand compared to last year when it was at its lowest ebb in the teeth of the first lockdown, or “base effects” as we might otherwise call them. The obvious pain point is likely to be in May of this year, as the base effects of April 2020’s negative – $37/barrel oil price and weak Sterling currency – kick in (oil is now trading at over $55 dollars a barrel as financial markets have grown to reflect the fact that one day people might hop on a plane again or fill up the car with petrol). This release of pent-up demand is likely to drive inflationary pressure. This may well spook investors – and bond markets in particular – but it will likely be short-lived, as the focus then shifts to a world still emerging from lockdown and confidence gradually starts to return to both consumers and employers. The more meaningful, more sustainable wave of inflation will likely take a couple of years to take hold: once the economy fully recovers from its lockdown scars.
We believe that this next phase could well be structural. A cynic might look at the US Federal Reserve’s inability to create above target inflation over the last decade (it has averaged 1.6%), but we would point out that 1) they have grown the money supply at over 25% in the last year, and 2) the Federal Reserve has now moved to an “average inflation targeting” framework. This means that they’re prepared to let inflation run a little hot – which is not the worst way of working off the enormous government debt.
In this environment investors need to be extremely targeted in the sorts of assets they own to protect themselves against the risks of inflation. This means more direct protection through having exposure to inflation-linked bonds (short-dated and targeting the US) and “real assets” such as gold, commodities and infrastructure. We’ve already seen these assets do well in the “reflationary” pulse that’s accompanied the vaccine rollout, and will look to add to them further as these forces build.
In addition to the more direct protection outlined above, investors should also be focused on other forms of indirect protection. For us, this includes short-dated credit (in particular, markets such as Asset Backed Securities, whose prices are linked to the value of a hard asset), emerging markets which benefit from the positive pulse of increased spending by the US consumer and thematic equities such as healthcare and green technologies that we see as huge beneficiaries from the likely wave of government spending targeted towards them. “Build Back Better” is at the centre of many government’s economic recovery packages; the focus is not just on the short-term need to rejuvenate the economy and livelihoods, but also on the long-term emphasis of safeguarding the future prosperity of our society. Within our thematic allocation we look to identify opportunities that are aligned to this long-term goal and contribute to a sustained long-term economic recovery.
Nobody knows for sure what the world after lockdown will look like; the new normal will take a while to establish itself. The forces of debt (too much), demographics (too old) and productivity (too low) may weigh further on growth, and it makes sense to hold some assets to reflect this. Our caution to investors is not to ignore the threat of inflation, as its warm rays will look very favourably upon certain assets that have been in the dark for much of the last decade.
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