December 2, 2021

Inflation Gets Complicated

by Dewi John.

There are textbook ways for investors to beat inflation. Unfortunately, we do not live in a textbook world.

Inflation chatter is always a thing, but the shocks are now coming thick and fast. Decades of globalisation had muted inflation, and the last time the Consumer Price Index (CPI) topped 5% was just over a decade ago.

Whether because of increased demand—the unfettering of post-COVID consumer spending—or supply side constraints such as too few lorry drivers or too little gas storage capacity, inflation is back on the agenda. The Bank of England has increased its inflation forecast to more than 4% by the end of the year, although it says it expects this to be temporary.

It’s a hazardous situation. In early October, Kristalina Georgieva, IMF Managing Director, wrote a “more sustained increase in inflation expectations could cause a rapid rise in interest rates, and a sharp tightening of financial conditions.”

While this is a global phenomenon, the UK looks especially vulnerable. Its labour market is tightening, with record job vacancy rates. The trade-off between inflation and employment, known as the Phillips Curve, is stronger in less open economies, which has become more of a UK characteristic since Brexit.

 

Attractive Assets

What, then, are the investment implications of this, particularly in terms of asset classes?

According to research published by the Bank of International Settlements, in periods of volatility, an investor having a pure inflation target should “increase her allocation to inflation-linked bonds, equities, commodities and real estate”. However, in a more stable economic environment, the portfolio should tilt to “nominal bonds, and to a lesser extent by commodities and equities”. Which begs the question: just how lucky do you feel about predicting volatility? Not a bet I’d be happy to take, for sure. If you’re looking for a real return target of between from 1% to 4%, BIS recommends a larger weight to risky assets, mainly equities and commodities.

Let’s take a closer look at the two main asset classes for most investors: equities and bonds. In January, finance professor Jeremy Siegel warned “higher inflation is coming, and it will hit bondholders”. This is because inflation reduces the real value of fixed income streams. Investors can respond to this through a combination of cutting bond exposure, shortening duration (the sensitivity of their bond portfolio to interest rate changes), and switching from conventional to inflation-linked bonds.

Equities, on the other hand, should be good inflationary investments, as companies can raise prices. Higher prices translate into higher earnings. In addition, inflation helps to erode fixed costs. However, a large inflationary shock means firms are faced with input costs such as materials and wages spiralling out of control, making it harder to pass on increased prices.

 

Sectors and Quality

Sectors vulnerable to higher inflation include high growth sectors such as Technology, as higher inflation can spur higher rates, which means a lower present value of future cash flows. Likewise, consumer staples—already on razor thin margins—may see those eaten up by higher input costs. On the other hand, sectors that can pass costs onto customers such as Financials and Energy should therefore benefit from higher inflation.

There’s another vital element to this, rooted more in fundamentals. For example, while the IMF’s Georgieva discusses government debt, she doesn’t touch on corporate debt, which has grown hugely since the global financial crisis. A rapid rise in interest rates would increase the cost of capital for companies. Those companies with anaemic cashflows, those that are heavily leveraged, or both, would face strong headwinds felt by both equity and bond holders.

‘Quality’ has been a focus for some active managers and smart beta strategies, with elements in this mix being low leverage, resilient cash flows and pricing power. If inflation persists, this factor will likely come to the fore. The corollary of this, of course, is that it’ll also become expensive.

 

It’s a Bit More Complicated Than That

Financial Times columnist Wolfgang Munchau argued last summer, “central bankers do not really understand how inflation works”. He added that “a random number generator, a monkey with a dartboard, or even a horoscope would have outperformed” the European Central Bank’s inflation forecasts. Munchau echoed a 2017 speech by then chair of the Fed, Janet Yellen, where she conceded “that our framework for understanding inflation dynamics could be mis-specified in some fundamental way”. Quite a confession from someone who’s main job is to control inflation.

 

Table 1: Lipper Global Classification Annualised Returns, September 2009 to September 2011 (%)

Source: Refinitiv Lipper

 

Inflation doesn’t change as all other factors sit quietly on the sidelines. For example, if we compare how fund sectors performed on the two-year upward trajectory of inflation from September 2009, peaking at 5.2% in October 2011 (table 1), Equity UK was the worst performer, returning an annualised 2.6%. Investors would have lost money after inflation on an asset that supposedly does well in an inflationary environment. Meanwhile, not only did inflation-linked bonds perform strongly (an annualised 10.5%), but so did “regular” gilts (6.4%). Similarly, the lower the equity content of mixed investment strategy, the better it did. This, however, was in the context of the post-financial crisis programme of quantitative easing.

Which leaves us with an untidy conclusion. As I’ve attempted to show, there’s little certainty on policy response to inflationary pressures. However, if inflation prompts rate rises to any significant degree, corporate bonds, particularly of heavily leveraged companies, will suffer—as will the shares in such companies. Hence why quality as a factor starts to look attractive. Such securities, however, will be as sought after as petrol has been.

 

This article was originally published in Personal Finance Professional

 

Refinitiv Lipper delivers data on more than 330,000 collective investments in 113 countries. Find out more.

The views expressed are the views of the author and not necessarily those of Refinitiv. This material is provided as market commentary and for educational purposes only and does not constitute investment research or advice. Refinitiv cannot be held responsible for any direct or incidental loss resulting from applying any of the information provided in this publication or from any other source mentioned. Please consult with a qualified professional for financial advice.

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