Having recently joined Ravenscroft as head of discretionary in Jersey, David Le Cornu shares his optimism about the economic and market outlook for the next year
I HAVE been in the disinflation camp for more than a decade, believing that the secular forces which put downward pressure on inflation including demographics, globalisation, technological disruption and monetary policy, would prevail.
While the long-term trend has remained intact, there have been periods when markets have anticipated rising inflation, but these periods have been brief due to the structural trends at play.
On the back of the global economic upswing, and forecasters upgrading their growth forecasts for 2021 and 2022, investment markets have recently been asking whether the current rise in headline inflation numbers is transitory or will it evolve into a longer lasting and stronger trend? This is probably the most important issue facing investors at the current time.
You may reasonably ask: ‘Why is this so important?’
The inflation outlook has a material impact upon the type of investments that will deliver attractive returns in the future. As money is a medium of exchange and our long-term aim is to preserve and enhance our clients’ spending power, we need to have a view on the future trajectory of inflation.
During disinflationary periods, you focus investments in long-dated fixed coupon bonds and equities that display predictable steady growth. The reason for this is that future cashflows from the bonds should rise in value over time as interest rates fall and the growth from the equities will become more highly valued in a disinflationary environment where growth is scarce.
In contrast, during periods of rising inflation, you focus investments in short-dated fixed coupon bonds, bonds whose coupon can rise such as inflation linked bonds or floating rate notes as well as shares that are attuned to rising inflation. This reflects an expectation that interest rates will rise over time making future cashflows less valuable and that growth in equities will only be valued if it is above the prevailing rate of inflation.
Inflation is a psychological phenomenon as well as a measure of prices. Everyone has become used to falling or low prices and it has become ingrained in the behaviour of consumers and businesses encouraging them to delay expenditure. Once this psychology changes and inflation expectations start to rise, it becomes a self-reinforcing process. If people perceive that inflation will pick up, they start to bring forward purchases, hold less cash and demand wage rises. Companies, expecting higher input costs and selling prices, will start to hold more inventory and working capital.
The main rationale in favour of a new trend of rising inflation is that a return to the fiscal dominance and monetary accommodation of the late 1960s and 70s will overheat the global economy and bring about a change in psychology. In this scenario, the combination of unprecedented pent-up demand, rapid money supply growth and the transition from Covid relief to infrastructure, environmental and other productivity enhancing investment will come up against supply side constraints as a result of Covid and years of resource underinvestment. Hence, global aggregate demand will start to exceed aggregate supply with higher prices the result.
Several other factors imply that inflation is likely to surprise on the upside over time. One of the negative impacts of globalisation and the extremely expansive monetary and fiscal policies is that income inequality has worsened. This has led to rising populism (as evidenced by Brexit and Trump), more extreme politics on both sides of the spectrum, a move away from globalisation towards ‘on-shoring’ production and calls for higher minimum wages, together with the introduction of a universal basic income. Demographics in the US will also play a part here as the retirement of baby boomers entails more consumption and less production and is, therefore, inflationary. These trends are likely to accelerate putting upward pressure on companies’ input costs, which can be passed on to consumers as demand increases.
As ever with economics, while the case for higher inflation is gaining traction, there are also several reasons why this could once again prove to be a false prophecy. The strongest argument against becoming overly concerned is simply the aforementioned- secular disinflationary forces, which remain dominant and powerful. If anything, their strength has grown due to the pandemic as global savings have boomed, the digitalisation of economies is accelerating at an even faster pace, global debt levels have spiked higher and global demographics continue to deteriorate.
It will also take most economies, such as the US and Europe, another two to three years before they return to their pre-Covid growth trajectory, even with the predicted recovery in activity forecast for this year and next. In the meantime, unemployment remains high, there is plenty of excess capacity in the economy and there is no guarantee that consumers will embark on the widely expected spending spree given that we all have to learn to live with Covid for some time yet.
I remain optimistic on the economic and market outlook for the next year or so. Liquidity remains plentiful and all of the necessary conditions for financial bubbles to thrive remain in place. This has to be tempered by changes in the geo-political landscape including China challenging the US for supremacy, the growth in populism and the waning of globalisation.
My conclusion is that there is a rising probability that the current increase in reported inflation above central bank targets will eventually lead to a higher structural rate. However, this is likely to be a few years away so it is still too early to have a high conviction or to put all your eggs in the inflationary basket.
For the past decade, holding growth stocks and ‘buying on dips’ has been the winning strategy for investors. A more flexible investment strategy will probably be needed for the rest of this decade, and investors should begin to incorporate some hedges against higher inflation in their portfolios. The team at Ravenscroft is available to anyone looking to achieve their investment goals.
The value of investments and the income derived from them may go down as well as up and investors may not receive back all the money invested. Any information relating to past performance of an investment or investment service is not a guide to future performance and may not be repeated.
David Le Cornu has more than 40 years’ experience in the finance industry, 25 of which have been in investment management. He moves from Brooks Macdonald where he was a senior investment director and joins Ravenscroft as head of discretionary in Jersey. The newly created role will see David, who is a Chartered Fellow of the Chartered Securities and Investment Institute, working closely with Ravenscroft’s discretionary investment management team to grow the Jersey business.
