— Jun 29, 2021


Markets have continued their goldilocks drift upwards – limited gains but very low volatility. Equities are rising, fixed income is stable, property likewise. Industrial commodities (including oil) have retained their strong gains of recent months and the only movement of note has been gold losing a few percentage points (as a consequence of the US Federal Reserve indicating that interest rate rises were likely slightly earlier than expected, though still many moons from now).

Most market chatter has been around inflation. Is it coming, or will we have deflation, what should we do, how does one prepare? Inflation has been picking up, of that there is no doubt. Every day the newspapers report surging commodity prices, staff shortages and wage rises. These, especially the last item, are surely indicators of inflation, but they may be temporary.

In January we wrote that the macro-economic data will be lumpy – it will be far more erratic than we are used to as we emerge from an unprecedented lockdown with never-before-seen governmental intervention into every aspect of the economy. As such it will be hard to analyse – swings that would have caused alarm in the past could be simply noise as the global economy normalises.

We would contend that the inflation picture fits this with precision. The jump in inflation is steep, but to some extent this is to be expected. The economy is, in most sectors, performing without hindrance and those areas most affected by lockdown are re-emerging. This will inevitably provide a boost to the economy that will be reflected in inflation figures. You also have the lagged effect in supply chains; when economies or sectors slow down then companies reduce their stock purchases to reduce their inventory down to the level of forecast demand. The decline in stock purchases is, as a result, always steeper than the decline in underlying demand for the finished product. The inverse of this is also true, and this is what we are experiencing now – when economies recover then stock purchases increase at a faster rate than the underlying economy. The data suggests that it is restocking that is one of the main contributors to the little surge in inflation we are experiencing. The rise of oil also plays a part. But these are temporary forces that will dissipate over the coming months even if the economy continues to grow uninterrupted.

Our position is that the risk of more structural inflation are much higher than they have been, though not as a consequence of this temporary boost. The risk comes from policy error, from central banks fearful of choking off recovery and (quietly) noticing how this is stealthily reducing their pile of debt, allowing structural (wage) inflation to rise and delaying interest rate rises until it is too late. We have been positioning your portfolio with these risks in mind; we have unusually low exposure to debt investments.

Bursts of inflation are actually rare, though they leave a deep imprint on the mind. The hyperinflation of the Wehrmacht republic in the 1920’s brought intense distress to the population of Germany and consequences that devastated Europe. More recently the less intense inflation of the 1970’s saw prices rising by 20% per annum and the UK stock market losing 73% of its value in 1973. After rent freezes were eliminated allowing property prices to adjust freely and the Bank of England bailed out several small lenders (and provided a de facto underpin to the banking system) the economy recovered and the UK stock exchange rose by 150% the following year. The lessons of history are that when it first emerges, inflation affects the prices of all assets – equities, property, commodities, debt – all lose value. As time pases real assets (equities and property) recover and over the long term maintain their value. Equities have never once suffered a permanent diminution of their value from inflation. Though they do suffer at the beginning of it. This is where, counterintuitively, cash is a superb asset in the early stages of inflation. Other low risk assets such as debt investments (gilts, treasuries and corporate bonds for example) all suffer permanent damage from inflation. Cash and near-cash (short duration sovereign debt investments) will do too, but in the short term they provide excellent defensive qualities. Should equities and property fall if inflation rises, it will present us with the opportunity to buy these asset classes at reduced prices before they recover.

The data does not suggest that we will experience anything like the severity of the 1970’s but gradually increasing precaution is justified after a long period of strong investment performance.