Inflation: a story of competing narratives
Over the past six months, the prospect of increasing inflation has precipitated a shift on the markets from the winners of 2020 into financial and materials companies and other cyclical stocks trading on a low price to earnings ratio. The prospect of higher inflation initiated a rise in the Treasury ten-year bond rate in the US that started in October 2020. A rising bond yield suggested that confidence in the economy was increasing. A growing economy on the back of the rollout of vaccines for COVID seemed to suggest that sustained inflation was inevitable.
However, there seems to be a fundamental disagreement on whether substantially higher inflation will be a new norm or a transitory anomaly. Essentially, are we at an early stage of a new inflationary period, or have markets overreacted, and we will be continuing with low inflation within a year or so – along the same lines of pre-COVID.
Supporting the case for inflation is that there are unprecedented amounts of money being pumped into the world’s economies (quantitative easing). The world’s markets are flush with cash. Global issues such as closed borders, interrupting supply chains, record commodity prices, geopolitical tensions, climate change and water shortages, and significant infrastructure spending are all expected to contribute to sustained and substantial inflation levels. The latest data from the US support this argument as the annual inflation rate in the US soared to 4.2% in April of 2021 from 2.6% in March - the highest reading since September of 2008.
Running counter to an inflationary outlook is the argument that the interest rate rises are a merely temporary reaction to the opening of the economy from the depths of COVID, the super spends from governments and soaring consumer data around the world. This must be set against the much longer-term decrease in inflationary pressure through mega-trends such as technology-driven disruptions and ageing populations.
Figure 1: Australian Inflation Rates (ABS)
Figure 2: US Inflation (Bureau of Labour Statistics)
Six months of inflation does not usher in a new economic paradigm, and the current spike in inflation is likely nothing more than a blip considered in the context of the past 50 years. Despite this, those concerned by the prospect of inflation see this sudden rise as only just the start of a long-term rise. The other part of the inflation story is the position of central banks. Their consistent message is that inflation is not a genuine problem, and the economy can ‘run hot’ in the medium term to ‘inflate the debt away’. They believe that rates can be held at slightly above 2% and then reigned in through less bond-buying and higher cash rates at the sign that the economy has fully recovered from COVID.
Ultimately, no one knows what inflation will do over the next few days/weeks/years. We hold the view that, while short term inflation is probably inevitable, longer-term deflationary pressures will win out. Because we retain a long-term perspective, our portfolios will continue to weigh towards high-quality growth stocks, as we believe that the relative underperformance in technology and associated stock winners from COVID will be a temporary aberration. One point of contention is gold. As interest rates lift with rising inflation rates, holding actual gold (through bullion or Exchange Traded Funds) becomes less appealing because cash, bonds and other asset classes become more appealing. Our exposure to gold companies (NCM, EVN, NST) who sell gold at the spot price ($1761 USD an ounce) that is well in advance of its ‘All-in Sustaining Cost’ (<$891 USD per ounce for NCM) will generate free cash flow if the gold price remains above this cost – therefore returning money to shareholders, whereas owning gold directly is a different, more uncertain, story.
Our underlying philosophy is that the primary objective is to protect our clients’ wealth and then to grow it. Consequently, we maintain a diversified portfolio of quality companies, fixed interest, and property, consistent with clients’ appetite or aversion to risk. Ultimately, we believe that holding a diversified portfolio of quality assets is the best cause of action in the current world of economic uncertainty.
If your portfolio holds fixed rate cash, fixed income, and/or property (through lending rates), then these short to medium term inflationary impacts will affect your portfolio – managing these risks or acknowledging them are important to achieving outcomes.
