Inflation is no longer lurking, like a phantom menace, but instead a genuine threat in plain sight. We are in unknown inflationary territory. It is reaching levels – currently 7% in the UK and 8.5% in the US – not seen for decades. And it could reach heights never expected with the Bank of England conceding that a rate of 8% is just around the corner.
As a result, the word transitory is no longer applied to the inflationary picture. The Bank of England has removed all reference to the ‘T’ word. Clear evidence, if it was needed, that the inflationary game has truly changed.
The standard and much-repeated interpretation of what is happening points to a return to the wild inflationary days of the 1970s, when inflation reached a jaw dropping 26.9%.
But Catherine Doyle, investment strategist in the real return team at Newton Investment Management, believes that this time it is different. “While it is tempting to draw comparisons with the past, the interest rate backdrop is very contrasting: interest rates were nearly 20% in the 1970s and it was the end of the Bretton Woods era, to name but a couple of differences,” she says.
Financial historian Niall Ferguson presents a different narrative. “My sense is that we are not heading for the 1970s, but we could be re-running the late 1960s, when famously the Fed chair, William McChesney Martin, lost control of inflation expectations.”
This suggests a possible worse scenario than the normal paral- lels with the 1970s. With the current situation – being the 1960s – offering up just a taster for possibly more dangerous times ahead – when we see a real rerun of the 1970s.
Behind the curve
If you take the basis of the Fed and other central banks having lost control, this is a possible and terrifying scenario. Every inflation outlook central banks have released during the last 12 months has had to be upgraded in some form because inflation had exceeded expectations.
“The Fed is behind the curve,” Doyle says, “but to say that they have lost control is an exaggeration. They are compelled at this juncture to raise interest rates aggressively in view of elevated inflation figures.”
Some point to the fact that the Fed should have followed the advice of the third president of the United States, Thomas Jefferson: “Don’t put off for tomorrow, what you could do today” – meaning the Fed was far too late in raising interest rates.
On this point, Evan Guppy, head of liability-driven investment (LDI) at the Pension Protection Fund (PPF), says the Fed accepts its mistake. “The Fed themselves have acknowledged that they are probably starting to tighten policy too late and it is hard to disagree with that: they were still expanding their balance sheet in March when headline inflation hit 7.9%.”
Back in control?
However, Guppy says the Fed appears to be back on top of things. “They have made a pretty sharp pivot to acknowledging that they are behind the curve and that rates need to move up quickly and above what they perceive as the long-run neutral rate in order to get inflation under control. So, they seem to be back in control of the narrative again.”
Yet David Lloyd, deputy chief investment officer of public fixed income at M&G, presents another scenario – one shared by some economic commentators – which believes central banks cannot always control the mechanisms of the financial system. “There’s a fairly clear recognition that many aspects of the inflation we are seeing are just not something the central banks can control,” he says. “The Bank of England mandate, openly accepts that inflation may drift away from its target, and in times of crisis, may indeed do so quite significantly and for a protracted period of time.”
The jury is out
If central banks can lose sight of the ball, it begs the question: where will this inflationary situation lead? And where will it end? The war in Ukraine makes an already bad situation incredibly worse. It raises the prospect of stagflation, that unwanted com- bination of slow economic growth mixed with higher inflation: a nightmare for investors.
“Stagflation is one potential scenario,” Doyle says. “Although, corporate and consumer balance sheets remain healthy, the jury is out about the extent to which rising interest rates will curb demand and central banks will need to manoeuvre carefully.”
On the stagflation situation, Evan Guppy of the PPF warns investors to keep their eye on the UK. “If there is one country in the developed world most at risk of a stagflation-type scenario it is probably the UK,” he says. “Headline inflation is going to hit levels higher than the US and eurozone, whilst the outlook for the consumer is also bleaker in light of the limited cushion provided to households against rises in energy prices, exacerbated by the rise in National Insurance contributions.”
Yet Craig Mitchell, an analyst at workplace pension provider Nest, believes Europe also has big problems ahead. “The risks of the worst outcome – stagflation – are greatest in Europe, as it’s the most exposed to the fallouts of Russia’s invasion of Ukraine – Europe gets around 40% of its gas and 30% of its oil from Russia, with few easy alternatives.
“The impact on domestic energy will affect consumers and businesses through higher energy prices, as well as potentially limiting the available supply,” he adds. “On top of this, there are more direct trade impacts for Europe and financial condi- tions have been hit harder. Outside of Europe, we believe the risks of stagflation are lower.”
The end of moderation
This could also be evidence of a shift in the macro-economic outlook. “You could term it as the wrong kind of inflation,” Lloyd says. “In this sense, many aspects of this inflationary problem are supply side. The current increase in inflation is something that bears no resemblance to anything we have seen for decades. Unfortunately, the ‘great moderation’, which included, amongst other things, moderation in inflation, has sadly come to an end.”
This presents a genuine shift in the economic picture which investors cannot ignore and firmly puts to bed a transitory analysis. It also poses a dilemma for the Bank of England. How should it react? If it tackles inflation, growth could suffer further, if growth is given a boost, inflation could rocket. “Central banks are in a bind: do they support growth or do they try and tame inflation?” Lloyd asks. “On balance, they are still very much in the camp of supporting growth.”
A point shared by Doyle. “[Central banks] need to ensure that the economy is able to bear higher rates, given elevated debt burdens, making it a delicate balancing act,” she says.
This could lead to many taking a Private Frazer perspective from the sitcom Dad’s Army: “We’re doomed”. But investors are taking more of a Private Wilson approach to the situation: keeping calm and carrying on, taking the situation in their stride. “We have significant inflation hedges built into our portfolio,” Doyle says.
“As well as having some direct commodity exposure, many of our equities have strong pricing power and are able to pass on increased costs to end consumers,” she adds. “A portion of our alternatives in areas such as infrastructure and renewables have inflation-linkage embedded in their long-term contracts. We also have gold in our stabilising layer which is a time-tested inflation hedge.”
In any crisis, and in any market reaction to that crisis, an important factor would be how you went into it. If you went into it long of risk assets and risk assets suffer, then you will be licking your wounds. If you went into a crisis short of risk assets and they re-priced, then you may be eyeing the opportunities that could lie ahead.
“The situation that we are in at the moment is quite difficult to analyse and draw firm conclusions from,” Lloyd says. “Not only is the future especially uncertain but even if you could map it out reasonably accurately, it would still be difficult to have a clear view of what it means for asset prices.”
Much also depends on the investor and the overall investment approach. “From the perspective of a value investor, which I am, you look at the opportunities that have presented themselves following the repricing of assets,” Lloyd says. “At the moment, we have not seen an adjustment in prices of sufficient size and have not had the big blow-off selling of assets that we saw in previous crises.”
Also, the value signals are still pretty tepid, Lloyd says. “Bearing in mind the possibility of significant increases in interest rates, which might come through from central banks. Extreme caution, waiting and keeping dry powder is warranted and is a sensible thing to be doing at this stage,” he adds.
The rise in inflation has inevitably scuppered the returns on some investments. “There’s been a lot of nerves over inflation and the path for interest rates, and the first quarter of 2022 has seen equities struggle with some of these headwinds,” Mitchell says. “There are not many assets that do well or are unaffected by quickly shifting global conditions. Equities are not immune from inflationary or growth shocks over the short term.”
Having analysed the situation for Nest, the majority of the investor pain so far has been in the bond markets, Mitchell says. “Higher yields in bonds means lower prices, which lead to negative returns,” he says. “On a hold-to-maturity perspective, the current level of yields and inflation means investors are still locking in negative real returns with government bonds and investment-grade bonds.”
From a portfolio construction perspective, another major implication of higher yields might mean that the stock-bond correlation returns to positive. “Investors have benefitted from a 20-year period in which when stocks fell, bonds were likely to rise,” Mitchell says. “But prior to this, when inflation was persistently higher and more volatile, the stock-bond correlation was positive. If this environment were to return, then investor portfolios would lose that diversification benefit.”
The patient investor
Portfolio adjustments are part of the evolving situation for investors. “We recently added back a position in gold and, within our equity selection, are increasing our focus on companies which will weather an inflationary backdrop and even thrive,” Newton’s Doyle says. “We have bolstered our exposure to the energy sector and will avoid companies whose business models are likely to be vulnerable to rising cost pressures.”
Nest finds real assets appealing. “At Nest we are thinking about the implications of a shift to higher and/or more volatile inflation regime,” Mitchell says. “It could mean a greater role for assets like real estate and infrastructure, that have implicit or explicit positive links to inflation.”
For Lloyd, the uncertainty of the situation is a major challenge. “There’s an awful lot of further unknowns around global supply chains,” he says. “The long-term impact of sanctions, for example, which are almost impossible to estimate at this point in time, not knowing their duration or whether they will continue to be in place or even the extent to which they might bite into the economies of the developed nations.”
Therefore, he suggests, patience is an important investor virtue at this point. “Patience is likely to be the best strategy. And potentially, in the long-term, the best-rewarded strategy.”