Worried about inflation? Just pack your brolly
An estimated 5,000 Brits per day are expected to head to Portugal in the next week. That was inevitable once the UK government announced its ‘green travel list’. I can’t really blame them. Have you seen the weather outside?
For those of us unable to travel, another round of summer staycations looms. We’re used to checking next weekend’s weather, hoping it changes in time for a trip to the beach. But we know the drill. Make sure the wellies are in the car, wear an extra layer, pack the raincoat and whatever you do, DON’T FORGET THE BROLLY! As the saying goes, ‘Prepare for the worst, hope for the best’.
Investing is much like navigating the British summer. Hope isn’t a great strategy. You need to be prepared. Especially as market and macro forecasts work a little differently. Instead of one forecast that turns out to be wrong, you get lots – that also turn out to be wrong! While some forecasters think we’re in for a blistering heatwave, others predict a torrential downpour.
Take inflation. The numbers have been rising recently. What next? There are two main points of view, and they could hardly be more different.
Two views: temporary vs sustained
The temporary inflation camp reckon that once you scratch beneath the surface of the numbers you see a clear story. Television prices have shot up and new furniture is expensive. For now, plane fares remain depressed but once we are fully reopened, plane tickets may go up – check out flights to Portugal if you don’t believe me! But at the same time fewer people will be spending money on DIY…
Eventually, these waves of spending will subside, and inflation will fall back to pre-COVID levels.
The sustained inflation camp takes a different view. They point to the huge amounts of stimulus over the past year. While the 2008 financial crisis saw tens of billions worth of stimulus, the COVID crisis has seen tens of trillions. This reckless disregard, they say, for fiscal and monetary prudence can have just one outcome – inflation. Lots of inflation… it’s just a matter of time.
At 7IM we think elements of both views are true. While much of the rise in inflation is temporary, we do believe that the massive stimulus will push inflation to a slightly higher trajectory than in the last decade.
But we won’t see 1970s-style inflation in the double digits, since there are also powerful offsetting forces. The biggest of those is wages. Unemployment is still high. Workers will struggle to extract big pay rises when companies can pick from the huge pool of people that still don’t have jobs. Until wages can rise sustainably higher, inflation is unlikely to surge and stay high.
Positioning for more than one outcome
But our forecasts may not be right either. We don’t just turn up to the beach in flip flops and sunglasses, and we don’t just tilt portfolios to one view. Instead we manage the risks, making sure we are prepared for other eventualities. We do this in several ways:
- Build the right long-term portfolio. Investors who are worried about inflation tend to think about the short-term impacts it may have on bond and equity markets – the suggestion seems to be to go to cash and wait it out. But if you take a step back, we invest to protect and grow our clients’ purchasing power. The raison d’etre of a multi-asset portfolio is to generate inflation-beating returns. Sitting in cash won’t help!
Our long-term portfolio, the Strategic Asset Allocation (SAA), is built with this in mind. It includes assets like our alternatives basket, as well as real estate. So, rather than lose sleep over short-term volatility, our clients know that our portfolios have grown faster than inflation over the long run and are designed to keep on doing so.
- Diversify away from the losers. We try to position our investments to align with our views. But good portfolio construction means we need to balance those investments with holdings that do well in other environments, all the while not hurting client returns in the process. We thus look out for up-down asymmetry in the markets.
Take government bonds. If our view – a strong-growth world where inflation rises – plays out, then bonds are facing more capital losses. So, we own much less of them – our clients’ portfolios will do well if inflation surprises to the upside. But what if we’re wrong? What if growth disappoints and inflation turns out to a be damp squib? With interest rates where they are (basically zero), the scope for further gains is limited. Bonds can’t make much more from here anyway.
- Every situation has a winner. Much of the talk surrounding inflation focusses on the negatives, but there are assets that benefit from inflation. Especially certain types of equities. In the last cycle investors worried about how low economic growth and possible deflation would affect company profits. As a result, they flocked to US technology companies – where profits were all but guaranteed – irrespective of valuations. This was at the expense of cyclically sensitive companies.
Now that we have the opposite situation, with strong growth and possibly rising inflation, those past losers may be the winners in the next cycle. We are tilted towards this part of the market, including mid-cap stocks, industrials, financials and emerging markets. If inflation is higher than expected, we think these will benefit portfolios.
The headlines over the next few months will be around sharply rising prices. There will be speculation about how the Fed and other central banks will tighten policy. Grave commentators will warn about how this will lead to short-term losses on equities and bonds.
The temptation to act – to DO SOMETHING – will keep growing. And to what end? Sit in cash? No, thank you.
Instead, investors need to stay invested to protect their wealth against any inflation, high or low. And we will play our part. By building an inflation-beating SAA with a strong alternatives allocation. By reducing our exposure to government bonds which we know will struggle to deliver returns, whatever the scenario. And finally, by tilting portfolios towards unloved equities that have been waiting over a decade for exactly this world.
Just like making the best of a staycation, we don’t aim to get our forecasts exactly right, because that’s not possible. Instead we aim to get our preparation right.
Capital at risk. Any reference to specific instruments within this article does not constitute an investment recommendation.