A four point defence plan for inflation
In this note, I want to dig a little more into the topic of inflation, which I first mentioned in my comments of August last year. Raising the subject of inflation, in the middle of a pandemic that crunched economic activity, may have seemed a touch unusual. However, there’s now growing investment industry recognition that inflationary pressures are on the upswing and the world’s long holiday from destructive inflation, which dates to the 1980s, appears to be winding down.
This has important bond and share market implications and thus for investors’ portfolios.
Let me begin with the bond market.
Complicating assessments of how bond markets may behave should higher inflation emerge is the realisation that ‘price discovery’ – the process by which market prices adjust in response to information changes – has been absent from the bond market for some time.
Instead, bonds have traded on ‘forward guidance’ (where the US Federal Reserve (the Fed) charts what they believe, on current information, will be the path for future interest rates), and been heavily influenced by central bank intervention through Quantitative Easing (QE).
These two forces, in combination, have pushed down bond yields (pushed up bond prices) to levels barely imaginable by previous generations of bond investors.
For the record, current Fed guidance is for no increase in official US interest rates until 2024. To be clear, ‘guidance’ doesn’t equal a guarantee. Nevertheless, all this has subdued price discovery and resulted in bond market instability.
Unexpected changes in forward guidance (or dialling down QE) could have outsized impacts on bond prices as investors have been unable to work out the ‘fair’ price for bonds due to these interventions and policies.
This matters, as central banks are about to face-off against an uptick in inflation. What happens then?
Will higher inflation be transitory or persistent?
Annual US inflation, as measured by Consumer Price Index (CPI) movements, is poised to blow through the 2% mark; 2% typically being the level considered consistent with price stability. The pandemic caused an abrupt price decline last year as the global economy came to a halt. This created an artificially low base from which prices can rise as the vaccine rollout and government stimulus reignites spending activity.
The first-quarter 2021 report on economic growth, released in late April by the US Bureau of Economic Analysis in late April, said prices grew at a 3.5% annualised rate in the March quarter and are up 1.7% from a year earlier. This sizeable price rise is largely attributable to the base effect stemming from last year’s price collapse.
Base effects, however, are not the only explanation for inflationary pressures. Supply constraints arising from the pandemic have seen shortages in certain sectors, resulting in price increases also.
For example, there’s a global shortage of microchips, which affects industries from autos to TVs.
Investment legend Warren Buffett, whose Berkshire Hathaway conglomerate is active in many US industries, noted:
"We’re seeing very substantial inflation. It’s very interesting. We’re raising prices. People are raising prices to us, and it’s being accepted.”
No doubt, some shortages will be overcome as resources gradually come back online, and so some price increases will be transient in nature.
However, some companies and industries will aim to address their supply vulnerabilities – perhaps by looking for suppliers closer to home – to avoid being caught out again and this will come at a cost. Think of it as companies moving from ‘just in time’ production to ‘just in case’ production.
How much of this cost can be absorbed by companies in lower profit margins or passed on to customers as higher prices, will take time to assess. But these effects are unlikely to be temporary.
Another contributor to inflationary pressures has been the level of stimulus provided by governments putting money into people’s pockets and increasing disposable incomes by doing so. It means that pent-up demand, as economies reopen, is chasing constrained supply in certain sectors, increasing prices.
Again, these could be temporary but once a company has made the decision to put prices up, they tend to be reluctant to lower them again absent an economic shock. Price rises tend to be sticky.
Bond and share market implications
Inflation is bad for bond prices as their regular interest payments become less valuable in an environment where prices are going up. In a normal functioning market with price discovery, we would expect bond prices to adjust lower to reflect the inflationary pressures.
Central banks, led by the Fed, are making reassuring statements that a rise in inflation will be temporary, and inflation will return to a comforting 2%. Based on current information, this may be a valid assessment. However, if the information changes so will investor views and potentially so might central bank actions.
Recent unguarded remarks by US Treasury Secretary Janet Yellen, who previously headed the US Federal Reserve, give an inkling into thinking at the highest levels of American policymaking when she said that US interest rates may need to rise to prevent the economy from expanding too rapidly.
The US Federal Reserve — not the US Treasury Department — sets American interest rate policy, but Yellen’s remarks fuelled concerns that policymakers believe the economy is at risk of growing too quickly and may need to be slowed down, perhaps by interest rate rises.
President Biden has proposed more than $US4 trillion in additional spending programs that would be infused into the economy over the course of the decade. The White House says those programs will be paid for with new taxes. Those tax hikes could in theory reduce their inflationary impact because the government would be taking about as much money out of the economy as it is putting in.
But the administration has proposed levying those taxes on corporations and high-income Americans, meaning the hikes may do little to slow economic demand because the rich spend a smaller portion of their income than do recipients of the new federal programs.
Regardless of the fate of President Biden’s proposals, as of now, expectations for higher US inflation, whether temporary or not, also has implications for shares.
This can be done by unpacking what’s happened in the US S&P 500 Index; overall earnings are down around 9% since last year yet share prices are up about 35% over the same period! This has been made possible by the price-earnings (PE) multiple expanding from 18 to 27 times.
The elevated PE multiple will be at risk if inflation increases. Our research suggests PE multiples are negatively impacted by rising inflation – any increase in inflation results in a decrease in PE multiples.
To be clear, the research is not saying inflation is bad for shares, but it is bad for PE multiples.
This makes intuitive sense as increasing inflation is a potentially unrewarded risk factor for a stock.
Some companies will have the pricing power to pass on increased input costs and others will have to absorb them as reduced profit margins. The added risk of determining how each company will navigate this dynamic could be reflected by investors assigning lower valuation multiples on the earnings to compensate for uncertainty.
We may enter an environment where companies still deliver on their expected earnings growth, but markets don’t move or perhaps even fall as the valuation multiples paid for those earnings contracts.
How we’re positioning portfolios
Our response in MLC’s multi-asset portfolios has been to limit government bond exposure and instead seek protection against interest rate and inflation risk by preferring inflation-linked bonds. The defensive component of our portfolios’ is also being strengthened by turning to gold and foreign currency, as well as volatility-related derivatives for managing potential market turbulence.
Consistent with our ‘participate and protect’ strategy — where we aim to give investors’ portfolios access to share market returns while protecting against the risk of falls — we introduced a protected US share market exposure. The structure allows for cheap participation in US share market rallies (up to a point) while avoiding exposure to falls beyond a lower bound.
We also purchased a currency option to buy US dollars and sell Japanese yen to help protect the portfolios against the possibility of share markets falling at the same time as interest rates rise.
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As Chief Investment Officer, Jonathan leads the investment team and assumes overall responsibility for the investment outcomes of the MLC portfolios for both retail and institutional clients. In addition to the Multi-Asset portfolios, he is...