Could yesterday's winners become tomorrow's losers?

Joy Yacoub

Pella Funds Management

For over a decade conditions for most asset classes could hardly have been better with low interest rates and benign volatility. This was underpinned and turbo charged by the injection of trillions of dollars, euros and yen into the monetary system by central bankers who had been lulled into a false sense of security by year-upon-year of (almost) non-existent inflation.

I sat down with Pella's CIO and Portfolio Manager, Jordan Cvetanovski to discuss some of the challenges investors are facing. In this wire I provide an over of the key points. 

1. The return of inflation is structural 
2. We see a major pricing pressure on raw materials such as copper, lumber and zinc and 
3. We do not see inflation normalising in the short/medium term and therefore central banks are likely to act with more conviction going forward. 

The return of inflation is structural

We have now come to the end of this Pollyanna decade and are faced with inflation rates unseen for over 40 years. In February-2022, US CPI was 7.9% and Europe was not far behind with 5.9%.

Perhaps the most worrying element of the current inflation environment is that there are few signs of it abating. It is our belief that many of the inflationary pressures that have emerged in recent times are structural. 

We estimate that the inflection point occurred during the Trump presidency, when the US initiated a very assertive stance on trade with China. Of particular significance was its decision to cut off commercial access to the US and other western markets for Chinese companies like ZTE and Huawei. 

The resultant “trade war” created an incentive for countries to unwind, or at least duplicate, some of their long-standing supply chains, with many (including China) recognising the need to become self-sufficient. The effect was and continues to be inflationary. Subsequently, the COVID-19 global pandemic added to this inflationary momentum as supply chains became further strained.

Perhaps unexpectedly, COVID also triggered some seemingly permanent labour dislocations. For decades, the wealth-divide and the extraordinary gains that corporates/shareholders were reaping at the expense of labour endured unabated. However, it is to be expected that it could not continue to expand forever. While the growing wealth-divide remains a challenging and concerning issue, it appears that labour is now able to take a larger share of the corporate profit pool. When combined with an ongoing decline in immigration and a rapidly ageing population, most of the developed world is facing a shrinking labour pool that is demanding higher wages. This will be another significant structural driver of inflation.

Major pricing pressure on raw materials 

Looking at the supply side, we have already seen major pricing uptrend on raw materials such as lumber, copper and zinc as global base material production struggled to satisfy a resurgent global economy. While some of the logistics-related bottlenecks that are driving these price increases may unwind, we are still facing a structural shortage of base materials due to chronic under-investment over the past decade. This situation is not going to change any time soon and the resultant pressures will, if anything, only increase.

When it comes to the supply of raw materials, the latest straw on the proverbial camel’s back has been the conflict between Russia and Ukraine. This has not only brought forward some glaring imbalances in the supply of base materials and fossil fuels, but it has also put into question the supply of grains and fertilizer. 

The world hasn’t seen a concurrent food and energy crises since the early 1970’s and the flow on effects will be prolonged and will show up in unexpected corners of the market. 

Therefore, in addition to the many geo-political implications of the Russia and Ukraine conflict, it is certain to stoke further inflation.

Market implications

The initial response from central bankers was to raise rates both to curtail near term inflation and to anchor inflationary expectations. They started off timidly, presumably hopeful that the inflationary pressures would simply abate over time. However, for the reasons outlined above, we do not see inflation normalising in the short/medium term and therefore central banks are likely to act with more conviction going forward. This will catalyse a meaningful slowdown in economic activity and is likely to have a negative influence on asset values, particularly in the most expensive high-growth segment of the equity market.

Longer term, however, the US central bank (and many others) will be limited in how far they can raise rates, due to the enormous debt burden that their economies now carry.

All attempts at crystal ball gazing aside

Pella's investment process has been utilised for over 17 years and has successfully navigated through various market conditions. The one constant is that we embrace these variations. We face the challenges head-on, using a mix of high-quality structural growers for consistency, cyclical companies for agility and innovative companies for dynamism. We remain extremely disciplined on valuation and portfolio diversification. When it comes to valuation, our core methodology focuses on one key measure, free cash flow generation.


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The information in this wire has been provided for general information purposes and must not be construed as general or specific investment or professional advice. The Pella Global Generations Fund PDS and TMD are avaliable at www.pellafunds.com/forms.

Joy Yacoub
Head of Distribution
Pella Funds Management

Joy is the Head of Distribution of Pella Funds Management. She has built her career in funds management over the last 15 years. Prior to joining Pella, Joy was the Executive Director of Pengana’s International Equities division. Her experience...

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