One of the most significant top-down discussions impacting on asset prices today is inflation: are we heading into a period of inflation or not? The debate has been rumbling since the policy reaction to the pandemic, but is now reaching fever pitch as weve seen the first above-trend inflation data.
As European equity investors, we believe we must have a view. While it would be nice to simply claim we are ‘bottom-up’ and ‘fundamental’, we can’t ignore the polarisation in markets of the past decade, underpinned by monetary dominance and fiscal repression.
Duration – defensive/quality – assets have benefited from the low inflation period and short-duration assets – cyclical/value – have suffered. This part is simple to understand: medium-term inflation influences the risk-free rate (RFR) and it’s the RFR that the market uses to discount future cashflows.
If expectations are for sustained low inflation, then the discount rate is low and asset prices rise – and vice versa. the problem is that forecasting medium-term inflation is not so simple. Nothing causes normally amiable economists to become more tribal than asking them to explain the causes of inflation.
In this article, we explain why we believe the arguments for transitory inflation are something of a distraction and point to areas of the market that could do well as mid-term inflation emerges.
Monetarists vs Keynesians
Monetarists can ‘prove’ inflation is a consequence of broad money growth while Keynesians will eloquently explain that as the demand curve shifts faster than the supply curve, then prices rise.
The monetarist vs Keynesian arm wrestle has, we believe, become more visceral since the global financial crisis because excess money supply hasn’t led to significant inflation.
This has empowered the Keynesians to look for other rational reasoning of deflationary forces, such as demographic trends (declining workforce), technology (increased productivity and marginalised labour) and globalisation (lower cost supply) with post-crisis austerity the final straw.
Accordingly, when looking at the post-covid world, monetarists have less voice and the Keynesians argue these same three structural trends persist. Hence, any inflation we are seeing today is purely transitory.
This narrative is a function of the severity of the enforced downturn, which has impeded but, importantly, not destroyed supply. Therefore, as demand has recovered surprisingly quickly, supply is temporarily struggling to cope and prices have risen, if only temporarily.
The pandemic has changed voter tolerances, which in turn affects policy. This then has an impact on the economic backdrop and ultimately on inflation risk.
The post-covid regime shift is happening to address issues of inequality and climate change. The vulnerability exacerbated by the health crisis is creating tolerance of big government. Unlike after the financial crisis, when the response was fiscal austerity, today the electorate wants fiscal dominance. The newly created EU recovery fund, worth Euro750bn (£645.2bn), is such an example.
These, we believe, are inflationary forces. Big government is historically a poor allocator of resources compared with the private sector – it curtails supply. The British auto industry in the 1970s is a good example of this.
Addressing inequality at a micro level means a greater share of stakeholder profits going to wages rather than to shareholders and management. This would direct resources to lower income earners who have a greater propensity to spend and therefore drive demand.
Inequality at a macro level means infrastructure projects and providing incentives to invest, thereby driving full employment and reducing social scarcity. Full employment as
a policy is inflationary. The climate agenda is a wrapper to digest the fiscal shift but it is also inflationary in its own right. Net neutrality requires capital investment we need to build turbines solar parks and transmission networks, which creates demand for physical assets.
However, we also need to build the infrastructure with renewable commodities, meaning cement needs to be ‘green’ and steel needs to be low-carbon. Some commodity producers will invest and take advantage but others, previously running for cash, will be forced to close and hence we will finally see capacity come out of the market.
Consumers will be affected too, with tolerance for higher prices, especially if wages are increasing, for greener products and replacement demand driven by policy. Think replacing vehicles for hybrid or electric alternatives as internal combustion engine cars are being banned from urban areas. This is inflationary.
Environmental policy is affecting capital availability already. Financial regulation means asset allocators need to disclose environmental data with the fastest-growing asset class being ESG – environmental, social, governance – compliant funds.
These fund flows affect corporate capital allocation with environmental projects getting cheaper funding than brown ones. There simply isn’t cheap money available for coal, new oil or other environmentally challenging industries and hence over time there will be a squeeze of supply.
We know we are approaching peak oil at some point, but what happens if peak supply comes first? Prices rise – inflationary.
We believe there are some incremental inflationary forces at play, absorbing output gaps. These, combined with the perhaps abating ‘structurally’ deflationary forces will lead to net inflation, but on the condition of monetary complicity.
Importantly then, post-covid we have both fiscal dominance and monetary accommodation. Since the pandemic, broad money growth has been far greater than following the global financial crisis and we also have a banking system that’s fully functional, i.e. neither deleveraging nor working out bad loans.
Monetary policymakers are shifting their mandate to remain accommodative for longer with targets of full employment and average ‘synchronised’ inflation. This allows developed market central banks to stay ‘behind the curve’, meaning they do not feel the need to address the current inflation scenario.
There is also consensus that central banks want fiscal co-operation in support of their tired monetary bazookas and will manage the interest costs through yield curve controls if required.
With abundant liquidity meaning banks will be able to lend, even as savings are reduced, central banks printing money and velocity increasing, then prices will rise – inflation.
Cyclical stocks set to benefit
We believe arguing about the short-term transitory inflation numbers misses the key point. Yes, short-term inflation is spiking because of bottlenecks.
However, asset prices are based on mid-term inflation forecasts not crisisrelated data. Therefore, it’s mid-term inflation we need to think about.
It’s our strong belief that mid-term inflation will be sustained at above-central bank targets, albeit not rampant. Indeed, inflation-linked bonds are signalling as much. Yet, the ongoing polarisation of the equity market with preference for long-duration and growth equities suggest something different.
In our view, from a top-down perspective, the types of companies that could benefit from nominal growth are the short-duration equities and these are the cheapest parts of the market. We believe they are cheap hedges to the mid-term inflation risk that we have argued for above.
In addition, from a bottom-up perspective, it’s the same sectors and companies that will be direct beneficiaries of the political shifts we’ve mentioned. The environmental agenda is pro-investment and pro-cyclicality.
Companies in industries exposed to construction materials, utilities, automotive manufacturers and even banks through volume growth – all might benefit. This is also where currently the most compelling valuations are.
Likewise, the impact from more rebalancing of stakeholder profit shares and fairer taxes with bigger government is less onerous for European companies. This is simply because they have been operating under a more egalitarian environment for longer than other global regions.
As we move into a new regime of inflation, our valuation discipline has resulted in our fund ranges being exposed to short-duration or cyclical stocks, which we believe are well positioned in the more inflationary backdrop outlined.
Related: How to protect your wealth from high inflation – Robert Stephens shares some ideas on how to shield the value of accumulated wealth from high inflation.
(function(d, s, id) var js, fjs = d.getElementsByTagName(s); if (d.getElementById(id)) return; js = d.createElement(s); js.id = id; js.src = "https://connect.facebook.net/en_US/sdk.js"; fjs.parentNode.insertBefore(js, fjs); (document, 'script', 'facebook-jssdk'));