As the global economy comes out of hibernation, fears are growing that rapidly accelerating economic growth, fueled by unprecedented government and central bank stimulus, could lead to sharply rising inflation. Hence recent rises in government bond yields and the sell-off in many previously high-flying growth stocks as well as the funds that hold them disproportionately.
Tesla, for example, fell 11% in just two days between the 22nd and 23rd of February. Amazon was down 8.5% in February, since its high at the start of the month and the Nasdaq fell around 7% to the end of February from its mid-month high. Funds and investment trusts with more of a bias to high growth / new technology have also been challenged.
US mega-cap growth stocks led the market up last year, accounting for the lion’s share of global market gains. When economic growth was subdued and inflation and interest rates expected to remain low, growth stocks were perceived as attractive investments with reliable earnings. Investors were therefore prepared to pay higher prices for the stocks. Now, many growth stocks are falling because they are perceived as being relatively less attractive compared to depressed cyclical and value stocks with greater potential to outperform.
In an environment when inflation is expected to increase, it may well be the case that value and cyclical stocks benefit the most. But it is not clear that inflation really is about to take off in a big way. True, it may spike upwards over the next few months when compared to the extremely low level of a year ago. The expected year-on-year increase in the rate of inflation may well be exacerbated by supply constraints, as pent-up demand is unleashed when lock downs come to an end and companies, moribund for so long, struggle to keep up.
But it is easy to forget that there are countervailing structural forces, such as demographic shifts and technological advances, which may continue to bear down on inflation. It is also the case that the economic recovery might not be as rapid as some forecasters predict, especially if there are further setbacks in the fight against COVID-19.
Our investment manager Willis Towers Watson’s best guess is that there will be no need for central banks to raise official interest rates to contain inflation for the next two to three years because there is so much unused capacity in the global economy after its extended shutdown.
However, the enormous size of Joe Biden’s $1.9 trillion stimulus package, on top of the $900bn COVID relief bill passed last year is a concern.
“$2.8 trillion is a significant sum amounting to over 10% of US GDP", says WTW’s economics team. “While this need not lead to inflation – not all the spending will occur in 2021 for instance – it creates risks. There is a fair bit of guesswork on the part of policymakers (and forecasters more generally) in terms of how much beneficiaries will save versus spend. This is complicated by epidemiological uncertainties that will also impact household and business decision making.”
If bond yields continue to rise, they could further depress the prices of former high flying tech stocks. But this will not necessarily be a bad thing for the whole equity market if economic growth accelerates at the same time. “This is because earnings could also be more robust than expected. Rate rises are most harmful in a situation where rises are needed to contain inflationary pressure.”
So, what does this all mean for the Alliance Trust portfolio?
The Alliance Trust portfolio is structured to avoid taking big bets on countries, sectors or styles. They are so easy to get wrong. Instead, our stock pickers are chosen so that, collectively, they are investing in what we believe to be the best stocks across all parts of the market. By which we mean the growth managers finding the stocks that aren’t over-hyped but are most likely to deliver long-term growth expectations. Or value managers finding stocks that are not cheap for a reason but more resilient than the market expects. And quality stocks that are able to compound earnings long into the future.
Each stock picker is restricted to selecting just a handful of companies that offer the most exciting investment characteristics from their point of view. The resulting portfolio is diversified enough to avoid a blow up in one part of the market undermining the whole portfolio, while maintaining highly active positions which have the potential to drive outperformance.
Many of the companies in the portfolio have had to take a back seat in the last few years to US mega-cap tech stocks, but now that the market appears to be broadening out into a range of other sectors and styles, WTW is optimistic that the Alliance Trust strategy is well positioned to deliver future outperformance.
Stuart Gray, Co-Portfolio manager, said: "We have some stock pickers whose portfolios would benefit significantly from a rise in inflation expectations while others have portfolios that you might expect to come under valuation pressure as a result. In the latter case, we challenge the stock pickers on this and find they are in many cases relaxed about the inflation threat as they believe their specific companies can continue to grow in the long-run and are priced today at a reasonable enough level such that the future growth can still outweigh any pressure that inflation and higher discount rates may put on the valuation."
"In truth, no one really knows the future path of inflation, so it seems sensible to not take a big bet one way or the other, but own good companies that in aggregate can prosper, whichever direction inflation goes."
“Our portfolio contains growth stocks which can continue to grow whether or not inflation picks up because they are benefitting from structural dynamics that are not related to the rate of prices rises. For example our investment in Qorvo an American semiconductor company that designs, manufactures and supplies radio-frequency (RF) systems for applications that drive wireless and broadband communications, as well as foundry services, is likely to benefit from the tailwinds of the 5G transition over the next few years. RF systems allow mobile phones, tablets, or other internet of things devices to connect to the internet via the spectrum. The company produces significant amounts of free cash flows, has a solid balance sheet and operates in what is an oligopoly with only three players and very high barriers to entry."
“At the same time, we have many value stocks who are performing much better now that their earnings potential is being recognised as we start to come out of the pandemic.”
Past performance is not a reliable indicator of future returns.
Stocks mentioned above are for informational purposes only and should not be considered investment advice.
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