Investment Committee Notes October 2022
Introduction
This is the first in our series of monthly Investment Committee Reports that we will be writing and making available to all our clients to help provide an insight into our views and strategy. Up until now these have been primarily internal documents highlighting important data from our weekly diaries that frequently makes for complex and rather prosaic reading!
Moving forward we hope to do a better job of cutting through all this information and be able to provider a document that is insightful, interesting and offers a clear understanding of the direction that we are recommending for portfolios. Whilst these are lofty ambitions, we will do our best!
Inflation, Central Banks, and Bad Behaviour
It is hard to believe that inflation has only been on the rise for just over a year, the pace of the increases after a prolonged period of subdued prices have been as much of a shock as the rising costs themselves.
The comparisons with the 1970’s may be justified, but hopefully things are not too similar as back then price increases took over a decade to peak and were only subdued by equally high interest rates. It is human nature to look for patterns and guidance for direction, particularly when faced with unfamiliar conditions. Whilst there are similarities it is important to consider the current factors objectively and it seems to us that there is a combination of temporary and structural issues that are driving inflationary forces.
The temporary factors have seen a combination of supply chain issues and a consumer flush with cash after Covid restrictions continuing to spend. At the same time Russia has successfully weaponized energy, after getting Europe – and Germany in particular – hooked on low gas prices countries have faced a significant rise in costs as the Ukraine invasion unfolded and buying from Mr Putin became taboo.
Behind this there are also structural forces that are likely to mean inflation is going to be higher in the future. Low unemployment means workers can demand higher wages, this is exacerbated by a smaller workforce pool as the “baby boom” generation retire, and in the UK workers from the EU have left. The end of cheap goods from Emerging Markets looks to be getting closer, as they become wealthier and charge higher prices whilst our desire to re-shore production to areas closer to home will come at a cost. Energy transition is another long-term factor as the cost of the move to more sustainable energy away from fossil fuels will not be cheap.
Whilst the structural forces are likely to keep inflation higher than we have seen in the last two decades, it is the temporary forces that are likely to cause spikes in prices and lead to more volatility in inflation – Ruffer LLP recently highlighted this and that there are more similarities to the 1940’s and 1950’s when UK inflation hit double digits on three occasions and went negative twice!
Central Banks remain in a precarious position walking the tight rope of policy error; raise interest rates to curb inflation and risk choking off economic growth and restricting the Government’s ability borrow cheaply – not to mention destroying the value of the Gilts that the Bank of England already own that they bought in Quantitative Easing. If interest rates remain low, they appear weak in the fight against inflation; if this results in failure to attract capital this means a weaker currency and imported goods increase in price again.
The power of the bond market was demonstrated in the brief period that Liz Truss was Prime Minister; a plan for growth based on loose fiscal policy and low taxation with no clear way of paying for it was not well received. The result was sharp rise in benchmark Gilt yields that pushed up mortgage rates and the cost of borrowing, whilst the Pound hit a multi-decade low against the Dollar. With the Bank of England also having to step in to help pension funds liquidity by reversing their planned quantitative tightening chaos reigned as rising yields also sent equities downwards. This was not the only factor in ending the leadership of Liz Truss, but it showed how important it is for Central Banks and Governments to co-ordinate strategy and consider how markets will react to their decisions.
If it wasn’t clear before, the need to have a credible fiscal plan is now more evident than ever – something Central Banks would very much like to achieve as they look to undertake quantitative tightening and sell the Government debt that they have been buying. The question remains though “who is going to buy it and at what price?”.
Ultimately inflation may need to take care of itself, this means that rather then falling due to Central Bank action they are hoping that consumer behaviour changes as items become too expensive. So far it seems the consumer is intent on being badly behaved and is continuing to spend – a recent trip to Cardiff suggest to me there is little appetite to rein in spending despite rising costs.
At some point though costs will become too high and discretionary purchases will be cut first as a collective “belt tightening” will need to take place. The savings that were built up in the pandemic will be used up and spending will slow down as Government becomes less inclined – or able – to subsidise the consumer. This reduction in spending will slow inflationary pressures leading to lower growth, recession (we may already be there) and higher unemployment.
For many born from the 1990’s onwards they have known only low interest rates, cheap goods, and cheap credit to help fund purchases; many have not seen what most of us consider “normal” inflation and interest rates. There are also those that cannot conceive that the globalisation that provided us with an abundant source of cheap goods and capital will change, and they are under prepared for changing conditions. The adjustment and need to prioritise spending could be a painful shock to many.
Investment Strategy
This year has undoubtedly been one of the trickiest periods that we have faced with significant movements in asset prices and difficulty in finding strategies that provide diversification as investment all moved in the same direction at once.
The redoubtable 60-40 portfolio (60% stocks and 40% bonds) that has been the bedrock of passive investing for those that believe in a buy & hold strategy has had its worst year in a century – perhaps it will force those who felt that this was enough to provide diversification and strong returns to adopt a more thoughtful and flexible strategy.
GMO Investment has highlighted how we remain in “Super Bubble” with cross asset overvaluation and a final stage where assets appreciate rapidly – we may now be entering that stage for equities as conditions seem ripe for strong “bear market rally”.
Our strategy so far has been relatively simple a simple and relatively equal split between cash, multi-asset funds, equities and alternatives including commodities. In the short term with rising interest rates and a strong dollar this has been painful for some holdings – Gold for example prospers with lower interest rates has not performed as we expected or hoped.
The rapid rise of interest rates this year taught us a lesson about Index Linked Gilts that previously we considered a prize “bulletproof” asset. We had been concerned that rising interest rates would affect values but could not conceive how much they could fall even at a time when inflation was racing ahead. Thankfully we have exited long before they reached there low for the year so far after losing almost -50%!
It was a similar story for the US equivalent TIPS (Treasury Inflation Protected Securities); however, whilst their decline was not so severe, they are now offer a yield of 1.7% above US inflation which is a level they have not traded at since the Financial Crisis. It now seems that these remain a credible alternative to cash and would even perform in a period of deflation as interest rates would fall. The main risk is that the Fed raises interest rates even higher, but as we have highlighted Central Banks may adopt a wait and see strategy particularly with inflation appearing to peak in the US.
If interest rates in the US start to decline and the Dollar softens this would provide a tailwind for Gold and commodities; the risk for the latter is if the Global economy weakens and demand subsides. That said a look at the chart below shows that relative to the US Stock Market Gold and Commodities continue to look cheap.
Lower interest rates – or less prospect of increases – could also be a boost for risky assets such as equities; although this may well take the form of the bear market rally GMO describe.
Ultimately, we fell there could still be some way for equity markets to fall and until that point when we are going to be well rewarded for taking on risk we will not over commit.