Transitory or here-to-stay? The debate over the nature of inflation has dominated news flow, polarised opinion and concerned investors in recent times. Here we present our views on inflation, the potential impacts of higher inflation across asset classes and how we are positioned in this environment.
Key points:
- Our expectation is that higher inflation will persist, but at moderate levels.
- In an environment of moderate inflation, we favour real assets – equities and property.
- Long duration fixed income will likely suffer in this environment – and consequently, we would prefer short duration fixed income as a stabiliser asset in portfolios.
Transitory, or persistent?
Headline and core inflation figures are rising across many advanced economies. Already, eurozone inflation accelerated to 3.4% year-on-year in September – marking a 13-year high – while the core US PCE price index increased 3.6% in August from a year earlier.
This acceleration in prices is connected to the resumption of economic activity after a bruising pandemic and stringent lockdown measures, disruptions to global supply chains and higher commodity prices.
Our expectation is that higher inflation will persist, but at moderate levels. The continuation of ultra-loose monetary and fiscal policies will boost aggregate demand, thus creating demand-pull inflation. At the same time, disinflationary forces that have existed over the last decade will remain – including the digitisation of the economy and the aging population of the developed world.
What history tells us about inflation
History shows us that cash isn’t the worst performer in a period of rising inflation. The higher the inflation rate, the more interest rates are likely to rise. And if interest rates can keep apace with inflation, cash can potentially maintain its purchasing power – but that’s difficult to see in today’s environment of negative real rates.
Within fixed income, longer maturity bonds have tended to perform very poorly in inflationary times as they are impacted by both the erosion of purchasing power and rising yields, which drive the value of bonds lower. Meanwhile, equities have done well during inflationary periods, provided there isn’t an extreme shock.
For example, between December 1977 and December 1980 pricing levels increased by 28%. In turn, traditional asset classes were impacted as follows: cash returned just over 28%, maintaining its value; Treasuries returned 13%, underperforming and losing purchasing power; and equities returned over 50%, performing well.
Interestingly, property has behaved like equities during periods when inflation rates were between 2-4%. It tends to benefit from rents and market value increasing as well as debt being inflated away. Gold – the most talked about inflation hedge – has kept pace with inflation over the long term, but it has underperformed equities and been quite volatile too. The precious metal has no yield, so there is an opportunity cost in holding it. For this reason, it has tended to perform better in extreme inflationary environments when other assets experience very negative outcomes. Gold is also very sensitive to interest rates owing to this opportunity cost – and so, a rise in interest rates will likely see it underperform.
Positioning for moderate inflation
In an environment of moderate inflation, we would continue to favour equities. While equities will likely see an initial hit on valuation, there is a potential offset of higher earnings growth depending on the nature of the company’s business. The S&P 500 earnings yield has nearly always been higher than inflation, so higher inflation mechanically suggests a valuation decline. This valuation contraction would likely be greater for the NASDAQ 100 and high-growth tech names, which are currently trading at the highest valuations. Cyclical, value and small cap stocks may do relatively better in this environment.
Amid expectations of higher aggregate demand, we would likely have a higher cyclical exposure than in the last cycle. Within that, we would favour industrials because deep cyclicals outperform in rising moderate inflation. Inflation allows them to raise prices more easily as customers can pass on the cost increases. And if they are producers of the commodity that’s driving the inflation uptick, then they benefit from the inflation wealth transfer.
Value stocks are shorter duration, and so by definition, may see less valuation compression. Value indices may be more weighted towards financials – and they typically benefit from higher interest rates and yield curve steepening which tends to happen in inflationary periods. However, markets may begin to worry about higher default rates in a higher inflation and interest rate environment. In that environment, we would likely reduce our banking exposure over the next 12-24 months and move into more structural growth stories in the financials space.
Higher inflation may also benefit small cap stocks more than larger companies, if it improves their ability to increase prices more aggressively.
Another real asset we would favour in this environment is property. Real estate may be a good hedge if rental income growth can keep pace with inflation. However, it is a long duration asset, so could see valuations decline.
Fixed income tends to trail other asset classes in an environment of moderate inflation – and so, we would underweight this asset class. Long duration fixed income will likely suffer as nominal yields increase. Consequently, we would prefer short duration fixed income as a stabiliser asset in portfolios.
There’s no need to fear inflation
Some investors are worried about inflation, but we’d welcome a modest rise in inflation after a decade of ultra-low interest rates. As we have mentioned, we believe a diversified basket of real assets – equities and property – and an underweight position in fixed income will help investors position their portfolios for a moderate inflationary environment as the world continues to recover from the coronavirus pandemic.
To find out more about our views on inflation, watch our recent panel discussion here.
The Goobody Investor Summit
On 30 September, we held the inaugural Goodbody Investor Summit, bringing together some of our brightest minds for a morning of engaging panel discussions and thought-provoking sessions.
Our virtual event delved into the key issues and themes shaping the investment landscape – from inflation and negative interest rates to environmental, social and governance (ESG) investing and the art of picking great companies.
Missed the Investor Summit or want to revisit a topic? Catch up on the sessions here.
