Financial markets are shrugging off some eye-popping inflation figures but should investors be worried?
Inflation is transitory. So say central bankers – and it is a line that bond and futures markets appear to be toeing. However, as recent inflation prints on both sides of the Atlantic overshoot even the uppermost estimates, should investors be prepared for it proving more permanent?
Consumer prices n the UK rose by 2.4% year-on-year in June. In the US, they surged by 5.4% – the highest reading since 2008. At least some of the rise in prices can be attributed to base effects – comparisons with last year when lockdowns to tackle the coronavirus pandemic hit supply chains and consumer spending and pushed inflation to near zero.
Increasingly, however, some policymakers and economists are making the case for this being no momentary spike.
Money supply is high – a reversal from the years that followed the global financial crisis when austerity was the order of the day. Banks are in a very different position, too. Their far stronger capital bases put them in a good position to lend to consumers and businesses whose credit profiles are generally healthy.
And the trend for globalisation that has exerted downward pressure on prices for decades has reversed. The switch from America outsourcing of manufacturing, particularly to China, to reshoring that started under Trump has continued under President Biden – and could lead to higher prices in general.
Lastly, ‘independent’ central banks seem to be siding with governments on the need to inflation debt away. While no-one is expecting a return to the rampant inflation of the 1970s, some warn that this period of more rapidly rising prices could last a few years, not just a few months.
With so much uncertainty, many may question what approach to take with their investments. The answer may lie in taking a diversified, stock-by-stock approach. By putting together a portfolio of ten best-in-class managers, Alliance Trust blends investments styles to produce an overall portfolio that is style agnostic. In a recent research note, analysts at Stifel pointed to the ‘solid job’ the Trust is doing in delivering long-term capital and income growth to shareholders.
All our managers are expert stock-pickers; their focus is on running high conviction portfolios based on individual company fundamentals. That said, they are not investing in a vacuum so are acutely aware of the wider macroeconomic environment within which they select stocks.
So, transitory or structural, what are their views on inflation? Let’s consider the thoughts of four of them and how they are positioning their portfolios.
Jonathan Mills and Simon Denison-Smith, founders of the UK-based value investor Metropolis Capital, are responsible for a portfolio that is worth 9% of Alliance Trust. Inflation was the subject of their most recently quarterly letter to investors.
Transitory or structural? For them, there is credibility in both arguments. “We have no house view as to what will happen to inflation and indeed do not believe we have an edge in macroeconomic calls,” they said. “We focus on understanding the competitive dynamics of industries, combined with bottom-up, company-specific analysis.”
They deem it useful, nevertheless, to understand the possible implications for the valuations of different equities should inflation accelerate or persist. The 1970s were testament to inflation causing real earnings growth to stagnate and price/earnings multiples to compress – in other words, for stocks to generally get cheaper.
The companies that stand to thrive in an inflationary environment are those that are capital light and have strong market positions and, therefore, pricing power. Commodity producers and highly indebted businesses may also benefit from high inflation but they warn that a high degree of caution is needed here because economic disruption and turbulence often accompany periods of heightened inflation.
“In periods of economic uncertainty (when is it ever certain?) we double down on trying to identify quality businesses, which are mispriced on their fundamentals,” they wrote. “We take comfort from the fact that our portfolio businesses all have durable moats and, in many cases, decent pricing power, that will demonstrate resilience if choppy macroeconomic waters lie ahead.”
Lyrical Asset Management
New York’s Lyrical Asset Management is another value investor. Chief investment officer Andrew Wellington manages 8% of the Trust. His colleague, portfolio manager John Mullins, addressed inflation in the firm’s second-quarter review conference call with investors.
“While the Federal Reserve believes these inflationary pressures are temporary, many of our investors think otherwise and have been asking us about how we may perform in an inflationary environment,” he said.
“Until this year we haven’t seen a period of secular inflation for a long time. In fact, to find a period where the consumer price index remained above 4% for more than one year, we need to look back about 40 years.”
Since 1960, there have been three such periods of elevated inflation and in each, value (as defined by the cheapest quintile of stocks) outperformed the S&P 500 index. The most extreme case, in the 70s and early 80s, saw inflation average 9% for a decade. During that time, the cheapest stocks outperformed by 10.8% per year.
“While value stocks in general have worked in highly inflationary times, it’s the quality of our companies that gives us confidence they can manage inflation,” said Mullins. “We own good companies at Lyrical with competitive moats that allow them to handle periods of macroeconomic stress.
“In our funds, returns on capital have averaged more than 20% over the past five years. These high-return businesses have advantages that protect them in good times and bad, with or without inflation.”
Value investing, he added, has also worked in periods of low or no inflation. That could be relevant if worries about growth being derailed by new strains of Covid-19 prove justified and we see a period of stagflation or even deflation. Since 1960, inflation averaged below 3% about half of the time and during these periods cheap stocks outperformed the S&P 500 by almost 3% annually.
Wellington concluded that concerns over inflation are not important for the performance of Lyrical’s portfolios or value stocks in general.
“In the end, for us, success or failure depends on our companies continuing to execute well enough to justify higher valuations than the low ones we pay,” he said.
Rajiv Jain, chairman and chief investment officer of growth investor GQG Partners, and manager of 15% of the Trust, thinks the market is underestimating the pick-up in inflation.
He sees a high correlation between some large cap growth stocks and bond yields, so investors in those stocks are taking implicit bets on interest rates staying low.
“I think inflation is going to be stickier than the vast majority of people believe and the equity markets are not pricing that in,” he said..
While a value manager like Metropolis avoids commodity producers, such as metals miners, oil and gas extractors and lumber producers, it is these very companies that Jain has been buying.
Such companies own and sell real assets that are key inputs to other companies’ production and are often the very basis of inflation. It should come as little surprise that as economies have reopened and commodity prices have rallied, fears over inflation have grown.
Jain has been increasing exposure to oil stocks, such as American energy operator Exxon Mobil and Brazilian state-owned Petróleo Brasileiro, and mining and materials stocks, such as Brazil’s Vale.
That has been at the expense of technology stocks, including the large Chinese tech names that are coming under increasing political pressure from the Chinese government for becoming too powerful.
In fact, regionally, Jain now has more invested in the raw materials-based economies of Brazil and Russia combined than he has in China. “We are very nervous about China,” he added.
Sustainable Growth Advisers
As its name suggests, sustainable growth is the focus for Connecticut-based SGA. Its three co-founding principals, George Fraise, Gordon Marchand and Rob Rohn, manage a portfolio that is worth 11% of the Trust.
In the company’s second-quarter update, it pointed to investor caution over concerns about rising inflationary pressures, the threat of new Covid variants, rising tax rates and higher regulatory costs in the US.
“Investors may also be recognizing the largest fall off in fiscal accommodation since World War II and questioning whether this could derail or slow the global economic recovery,” it said.
This caution led to a change in stock market leadership, with appetite for cyclicals waning and higher-growth businesses outperforming by the end of the quarter.
SGA’s portfolio is positioned in the managers’ highest conviction and most attractively valued long-term secular growth opportunities. It remains overweight the information technology, consumer discretionary and healthcare sectors.
For this manager, higher inflation will not derail secular trends like the shift from bricks to clicks in retail or the growing need for innovative medicines and therapies.
Among the biggest contributors to performance in the second quarter were Novo Nordisk, a global leader in the treatment of diabetes and Internet search leader Alphabet, which owns Google;..
SGA expects elevated volatility in equity markets to continue, but ultimately, it wants to own leading growth businesses that can make their own weather.
“Our disciplined focus on predictable and sustainable growth businesses that we can access at attractive cash flow-based valuations should lead us to businesses that can continue to succeed regardless of the economic or regulatory backdrop,” it said.
Craig Baker, Chief Investment Officer of Willis Towers Watson and chair of the Alliance Trust Investment Committee, said: “Given the wide range of potential outcomes, reflected in the differences in views among our Stock Pickers, we believe that our multi-manager approach provides investors with attractive exposure to the right balance of return opportunities arising from the current macroeconomic environment, while also guarding against the risks of taking a binary view on inflation. Black and white thinking often feels safe and can pay off handsomely if you get it right, but it can also prove very expensive if you make the wrong call.”
Past and expected performance is not a reliable indicator of future returns.
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