Client Update - 26th November 2021
The default investment strategy for 2022 has to involve accounting for interest rates potentially being increased in the UK and in the US. This is already priced in given the much higher than expected current and expected trajectory of inflation. There is no justification for central banks keeping interest rates at pandemic-crisis levels. The world is a long way through the pandemic and the global economy is operating at much higher levels of activity than it was when policy was dramatically eased in early 2020. That being said, we are clearly not there yet, as the latest surge in infections across large parts of, relatively well vaccinated, Continental Europe highlights.
Quite why certain geographies are seeing such accelerating trends currently, and others much less so, remains in debate. Undoubtedly there will be numerous factors including levels of vaccine take up, scale of previous exposure, particularly to the much more infectious Delta variant, and plenty more besides.
One could take the view that markets have already adjusted to higher inflation and potentially higher interest rates. Currently, equity markets do not think the tightening that is priced in is dramatic enough to derail a bull market driven by super strong nominal GDP and earnings growth. If that view is correct, let the central banks crack on. Indeed, if we are about to experience another COVID-related shock to economic activity, it may be that too much has been priced in and we are worrying too much.
The average monthly increase in the consumer price index (inflation proxy) in 2021 has been just shy of 0.6% compared to just under 0.2% in 2019. Inflation rates are higher everywhere. In its October 2021 World Economic Outlook, the IMF projected consumer price inflation at 2.8% for advanced economies this year with developing economies expected to register 5.5%. Those averages disguise some eye-popping inflation forecasts in individual countries – Turkey at 14.6% this year and 16.7% in 2022 stands out. As a region, Latin America is expected to see close to 10% inflation next year while economies in Africa and the Middle East are already experiences double digit price increases.
Investors need to have a view on two things for 2022. The first is what will be the evolution of inflation and the second is how to protect portfolios should inflation remain elevated, as it looks as though it will for a while. So far, bonds have not done a very good job of protecting portfolio values from the rise in prices we have already seen. In the US the consumer price index is up 5.7% since December 2020. A standard US Treasury index has registered a total return of -2.8% over that period. An investment grade corporate bond index is down 1.3%. In the Euro area, consumer prices (all items) are up 4.1% over the same period, but total returns from a European government bond index, year-to-date, are -2.2% and from a standard corporate bond index in Europe, -0.5%. Real returns have been negative in high quality bond markets. They are likely to remain that way for a little period yet.
We often wonder if those that talk so negatively about bonds, inflation and central bank policy have any equities in their portfolios. Equities have generally outperformed inflation by a long margin for many years and this year has been no different. The combination of the strong recovery in final demand and increased investment and the push towards greater sustainability in many has allowed many companies to exploit pricing power that have all super-charged earnings. Strong earnings, low interest rates and accommodative policy settings have made it an easy decision to be mostly exposed to equities. The more effective vaccine roll-outs in developed economies has also contributed to a better performance of developed versus emerging equity markets.
The global economy continues to be stressed by the relative strength of demand against a constrained aggregate supply curve. COVID is still impacting on supply chains and it is taking companies longer than expected to reduce order backlogs and deal with distribution logistics. The hope is that these tensions ease in 2022 with above trend demand for goods and below trend demand for services re-balancing going forward. However, high energy and food prices and evidence from many countries that real estate prices are rising rapidly are causes for concern. The real concern is what happens to wages and inflationary expectations. It is a stretch to argue that a wage-price spiral of yesteryear will re-emerge. It is not really in the DNA of companies to sanction inflation-busting wage increases year-after-year. By the same token, fiscal generosity is unlikely to be permanent.
When the Federal Reserve (Fed) last undertook a monetary tightening cycle it started off, in 2015, with a view that the terminal Fed Funds rate would be 3.5%. By the time the Fed has finished tightening the terminal rate estimate was 3.0%. Now the best estimate is 2.5%. In 2018 the Fed stopped raising rates 50 bps below what had then become its terminal rate forecast. Using the same logic, on the fundamental assumption that it takes less in terms of rate hikes to slow the economy, then we are perhaps looking at a 2.0% potential peak in Fed Funds. The market has not quite priced that in yet but is close to doing so. Nearly six hikes are priced in – the Fed did nine in 2015-2018. Thus, the path of monetary normalisation might not be that bad.
Whilst we invest in some shorter-term trends, we make the bulk of our investment decisions over a medium-term time horizon. Some stocks that have struggled in the last few years are now being picked up by the team if the investment story remains intact today. There is an argument that their respective competitive positions are getting stronger, compared to weaker peers in the same sector, the longer disruption persists. Whilst we might have hoped that the recovery would be further advanced by now than it is, we are reminded that ‘hope’ is not an investment strategy. Buying good businesses with excellent long-term prospects, at attractive valuations, and being patient enough to see those prospects come to fruition, seems to us to be a much more sensible plan. Please do have a good weekend.