“Only Government can take perfectly good paper, cover it with perfectly good ink and make the combination worthless.”
Milton Friedman, American economist and statistician.
Economists have been compared to monkeys throwing darts, often coming off worst in prediction competitions. Regime changes usually take a while to fully register with investors. Making forecasts at points of change such as the one we are experiencing at present, with the potential return of a more troublesome level of consumer price inflation, is akin to a monkey throwing a dart from a merry-go-round and therefore not to be trusted.
The clearest example is the unexpected behaviour of government bonds which, despite inflation and growth running at the highest levels in a decade, still yield only 0.6% in the UK and 1.3% in the US. With inflation running at more than 2.5% in the UK and much higher in the US, this just doesn’t make sense and bondholders are virtually guaranteed to lose money. Risk without return comes to mind.
Milton Freedman deduced that increases in money supply will drive inflation higher and ever since the 2008/9 financial crisis and the use of ‘printed money’ by central banks, the concern has been that increasing the supply of money in circulation would prove to be inflationary… eventually. When the scale of the Covid-19 crisis became evident last year, central banks, again, hit the ‘print’ button in order to protect economies from the financial consequences of lockdowns.
The US opted for helicopter money, directly putting deposits into the bank accounts of everyday Americans, and boosted unemployment benefits. The UK furloughed millions of employees, paying 80% of salaries for businesses forced to close or downsize during lockdown. Most other EU countries opted for similar schemes. As a result, western economies moved closer to the Japanese model, with artificially low bond yields as central banks drastically increased their ownership of government debt.
During last year’s lockdowns, inflation dwindled, with US CPI (a measure of inflation) reading 0.6% in July. A year later, the low figures have fed in as base effects, to push inflation up to 5.4% in July. UK CPI was similarly low at 0.6% in July last year and has now surpassed the BoE target by hitting 2.5% this year.
The question for investors is ‘how permanent will these inflationary pressures prove to be?’ Many businesses will see the chance to make up for lost profits by increasing prices and with many households still holding on to savings forced upon them by the reduced ability to consume, there will be demand despite higher prices.
“Transitory” has been the buzzword when it comes to inflation. Jerome Powell (Fed Chair) has consistently sought to reassure investors that the pressures currently impacting inflation will equalise as the impact of Covid-19 on supply chains lessens. This terminology has spread to other central banks, with Andrew Bailey (Bank of England) also expecting UK inflation to gradually fall away. Central banks are navigating choppy waters, under pressure to keep borrowing costs low, to allow historically high debt accumulation costs to be serviced, while hitherto unknown amounts of cash have been pumped into economies. So far, they are all holding the tiller steady, and markets are broadly convinced of their interpretation, with 72% of fund managers in July’s Bank of America Survey agreeing that they expect inflationary pressure to drop off next year.
But that is the trouble with inflation, and despite the reassurances that central bankers feel obliged to give, no one really knows where it will head and what it will take to bring it under control.
The risk of inflation is worth protecting against, even though the return of inflation is far from certain. Yes, inflation is an enormous risk when seeking to preserve and grow one’s capital, but so is positioning for it and it never materialising.
We continue to believe that a balanced approach, as opposed to betting on one outcome or the other, will produce the strongest returns for investors over time. Our key defences against inflation are low risk, short-dated inflation-linked, and conventional bonds and the pricing power embedded within our equity portfolio.
Amazon and Microsoft, for example, have sufficient dominance in their markets to counter any uptick in inflation by raising prices. Companies such as Visa and Mastercard would also not be adversely impacted as they would earn more fees on higher transaction values.
Alphabet, the owner of Google, has benefited from the shift from offline to online, caused by the pandemic. The digital economy is in a transition period from the one-off effects of the pandemic last year to a more normalised level of sales, and digital advertising has continued to be an important way for companies to find customers.
The fact that our portfolio of stocks is, in the main, cheaper than the market itself also offers another major source of protection. Whatever the future holds, we own assets which we believe will grow in value and given their starting prices, should generate strong price appreciation well ahead of inflation.
Fear inflation, protect against it but don’t bet the house on it. Or to put it another way, beware monkeys bearing darts!
At the time of writing the FTSE is trading close to its highest level since February 2020, as investors welcomed a batch of upbeat economic data, as well as strong earnings reports. Profit-taking by day traders is sure to follow creating some short-term volatility, exasperated by the tragic events in Afghanistan and hawkish comments from the Federal Reserve Bank of America.
The UK economy grew more than expected in July as lockdown restrictions were lifted, while exports of goods to the EU recorded above pre-Brexit levels for a second month.
Europe, which missed out on last year’s tech rally, given its undersize technology sector, has benefited from the investor focus on cyclicals and a strong recovery from the pandemic. European shares recently inched to their longest run of record high sessions in at least three decades. Sentiment has been supported by a strong earnings season and the prospect of a solid economic recovery in Europe, assisted by continued policy support from the European Central Bank.
In the US, the S&P Index and the Dow Jones Industrial Average recently hit all-time highs, after robust corporate profits ignited optimism on Wall Street that US equities will extend their bull run.
The latest quarterly reporting season showed US corporate earnings, revenues and profit margins expanding at their strongest pace since 2008. Economic growth has been running at the best pace in decades, which has been a tremendous tailwind for earnings. The S&P 500 is now up more than 18% so far this year and has roughly doubled from its March 2020 lows, when pandemic lockdowns threw global financial markets into chaos.
This has also been a good year for equities in commodity-exporting emerging markets, including Russia, Brazil, and South Africa. Despite a serious second wave of COVID-19 infections, India is experiencing a stock market boom, fuelled by extraordinarily easy monetary policy and an influx of foreign capital.
The Chinese government showed their hand in July, highlighting the significant political risk that investors must factor into their asset allocation. Chinese online tutoring companies, many of which had raised capital in US markets, found themselves forced to become non-profit companies and were not allowed to raise capital from overseas. Three of the prominent companies in the industry listed in the US saw their share prices more than halve in one day as the news of the Chinese government’s intentions leaked. Tencent suffered sharp selloffs in July on regulatory concerns and has now fallen c.40% from the start of the year. Its flagship WeChat platform has suspended new user registrations to align with new government regulations, intended to improve data security and market stability. The fallout from this political intervention has now seen Chinese equities lose all the ground that they made in terms of outperformance against other markets since the start of the Covid-19 pandemic.
Throughout history, economies have been shaped by shocks, from recessions to technological shifts and energy transitions. The Great Depression helped to change the thinking about the role of government, paving the way for a permanent expansion in the state. The switch from steam power to electricity triggered a vast re-organisation of manufacturing.
The coronavirus pandemic and the drive to ‘net zero emissions’ are similarly epoch-making events. The pandemic has driven technology adoption and changes in business practices. The energy transition involves an overhaul of energy production and distribution.
The structure of the economy will change. The sectoral balance of the economy, the skills needed, the uses of capital, the allocation of capital, will shift, creating winners and losers. It will also bring opportunities to rethink organisations, invest and raise productivity in ways that had not previously been considered viable or necessary.
The global semiconductor shortage has spurred a flurry of investment announcements in new factories. Automakers are building new battery plants to meet demand for electric vehicles. Rising freight rates have prompted a surge in new orders for container vessels. And the move to ‘hybrid’ working and the growth of online shopping require a reconfiguration of office space and an ever-rising volume of warehouse capacity.
A surge in private sector capital spending is likely to coincide with rising levels of public infrastructure investment, particularly related to ‘green’ projects. So, with private and public investment likely to grow, this recovery is looking very different from the one that followed the global financial crisis. Then UK business investment took six years to climb back to its 2008 peak. Today the Bank of England sees investment snapping back quickly, ending next year almost 10% above pre-pandemic levels. A similar story is likely to play out globally. Morgan Stanley believes that global investment will stand 20% above pre-pandemic levels at the end of 2022, a remarkable recovery from last year’s downturn.
The pandemic hit economies almost as a shock out of the blue, rather than as a result of a fundamental problem in the system that needed fixing. Returning as close as possible to the pre-pandemic economy is something to be celebrated rather than feared. We need and should be able to do better than the recovery from the global financial crisis.
Economic shocks tend to hold back house prices. But one of this pandemic’s peculiarities has been how it has supported housing markets. Despite bringing about the sharpest downturn in almost a century, the pandemic has fuelled a housing boom in the developed world. Among the OECD group of rich nations, house price growth has accelerated to its fastest pace in 30 years.
A lot has to do with the policy response to the pandemic, featuring ultra-low interest rates, income support programmes and tax breaks in some countries, which have boosted house prices. Additional savings by many, whose jobs and incomes were shielded from the worst effects of the crisis, and the growing desire for extra space, as people spend more time at home, also propped up demand for housing. Add to that the rising cost of building materials and a limited stock of existing housing and you have the perfect recipe for house price inflation.
Rising house prices are not necessarily a bad thing, especially as the global recovery picks up pace. They make homeowners feel better off and more confident about their finances, boosting their spending. However, many economists worry about the sustainability of these rises and the risk of a significant correction as monetary support is scaled back.
Perhaps monkeys throwing darts might be able to tell us more about the future path of both house prices and inflation but either way, prudent diversification of one’s investments will provide the best protection and growth prospects. The Clarion Portfolio Funds and model portfolios offer a simple, cost-effective solution with both wide geographical and asset diversification combined with active investment management by the very best fund managers.
As always, we wish all our clients, their families, and friends the very best of health and good fortune as we begin to enjoy the new normal and a life of comparative freedom. We continue to take all necessary precautions to ensure that our office is Covid safe and secure, for both staff and clients alike. We look forward to welcoming you to the familiarity of face-to-face meetings in Overbank in the coming weeks and months although if preferred we are happy to have client meetings via Zoom and/or Microsoft Teams. Please do get in touch if you have any questions.
We look forward to updating you regularly over coming months.
Keith W Thompson
Clarion Group Chairman
Creating better lives now and in the future for our clients, their families and those who are important to them.
Any investment performance figures referred to relate to past performance which is not a reliable indicator of future results and should not be the sole factor of consideration when selecting a product or strategy. The value of investments, and the income arising from them, can go down as well as up and is not guaranteed, which means that you may not get back what you invested. Unless indicated otherwise, performance figures are stated in British Pounds. Where performance figures are stated in other currencies, changes in exchange rates may also cause an investment to fluctuate in value.
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