Shaking the bottle
The last 20 years have been characterised by low inflation. The “genie” of inflation has been kept in its bottle.
Low inflation has gone hand in hand with the low-interest-rate environment we have been in. But we should not forget that the genie exists and may return unexpectedly, as it has in the past.
The large build-up of debt in the global economy, and the acceleration of its growth caused by COVID-19 reminds us that there are only three ways in which debt is reduced: default, growth or inflation. Default means it is never repaid, growth allows the economy more capacity to pay, and deflation lets the real value of the amount owed fall through time. There is much conjecture about the merits of each but suffice to say that each alternative impacts different parts of the economy in different ways.
In a period of subdued growth, and limited appetite for default in most advanced economies, the role of future inflation is becoming more relevant.
We outline the case for higher inflation over the medium term and how your portfolio is positioned for this possibility.
The status quo
Clients will remember the discussion around inflation at our CIO Events in February.
At the time, we highlighted that we were wary of assuming business, government and policy will not change.
We certainly did not foresee just how quickly this change could occur, as a result of COVID-19.
Governments and institutions reacted quickly to the crisis, providing an unprecedented amount of support for economies globally – beyond what previously was thought possible. This has challenged the status quo and views around inflation.
How have investors expectations subsequently changed?
The prospect of rising inflation is becoming a more frequent point of discussion. However, prices in markets are yet to reflect an inflationary view:
The reality is, despite having preconditions that are identifiable, inflation often catches markets off guard.
The inflation seen in the 1970s provides an example of this. In hindsight, preconditions were clearly present in the 1960s for inflation: aggressive fiscal expansion, a rise in consumption as baby boomers came of age and relentless pursuit for full employment.
Yet, it wasn’t until the 1970s that this was reflected in prices and translated into inflation.
We can draw parallels between the 1960’s and today.
Preconditions in 2020
COVID-19 has demonstrated governments’ willingness to:
- build enduring support for economic activity in all of its forms
- support nominal growth in economic activity; and
- defer possible painful economic adjustment
This has shaken the genie’s bottle and accelerated some of the preconditions required for inflation.
The unprecedented fiscal and monetary support that has been provided has led to a rapid rise in the global supply of broad money:
In contrast to measures implemented after the GFC, more of this support is ending up in consumer’s pockets. This, paired with limited spending due to lockdown restrictions and uncertainty has led to a spike in saving rates. As the global economy comes out of lock-down and with the continued support from governments and institutions, this money will look to find a home through greater spending. We have begun to see this in trading updates from Australian retailers - including Bapcor this week (see company news below).
Thus there are preconditions in place for inflationary pressure in the medium term. Yet, much like the 1960s, we may be caught off guard when this is reflected in prices.
Added these preconditions is the longer-term economic backdrop.
As a reminder, the large build-up of debt over the past two decades, which has accelerated recently, can only be resolved in three ways: default, growth or inflation.
Implications for your portfolio
Active portfolio management involves identifying when these preconditions are present and positioning accordingly.
With the potential for inflation not yet reflected in market pricing, there is scope to structure the portfolio to benefit.
This does not change our process for identifying investments: we continue to buy stocks that are cheap based on the cash flows they can generate in the future.
The companies in your portfolio are good investments on these merits alone. However, many of them will also benefit from a reflationary environment. This would provide a economic tailwind to your portfolio and potential additional returns.
We have also avoided investments that are purely a bet on low inflation in the future, which helps reduce the risk of being caught off guard by inflation.
Companies in your portfolio that stand to benefit in a reflationary environment include James Hardie, Boral, Incitec Pivot and Woolworths.
They also include resource companies such as BHP, Sandfire, Mineral Resources and gold producers Newcrest and Aurelia Metals.
Though the preconditions for inflation are often identifiable, it has historically caught the market off guard.
The rise in global debt levels, as well as the enormous fiscal and monetary support provided during COVID-19 has shaken the genie’s bottle: amplifying many of these pre-conditions.
While your portfolio has been constructed from the bottom up, it also has an eye towards the potential for change in the broader economic regime.
We see that the market is underpricing the potential for inflation over the medium term and have aligned the portfolio to benefit from this.