Investment Update – Taming Inflation – 1st September 2022
Economic and market overview
At the start of the quarter, three elements continued to weigh on market sentiment; there was no indication that the war in Ukraine would end soon, China’s Covid-19 lockdown continued to dampen economic activity in the region, and inflationary pressure around the world increased. In an effort to control inflation, the Bank of England and the US Federal Reserve (the Fed) sought to tighten monetary conditions, with aggressive interest rate rises dominating news headlines. Sentiment focused on the concern that rates might rise too quickly, threatening economic growth and risking recession.
In financial markets, volatility increased and most asset classes performed badly, with the exception of commodities and Chinese equities. Commodities initially found strength due to global shortages resulting from sanctions on Russia but wobbled toward the end of the quarter as the possibility of a global recession reared its head. Chinese equities benefitted towards the end of the quarter as lockdown eased. To exemplify the swings in markets, the MSCI World Index fell 9.1% in sterling terms, oil rose 6.4%, while gold fell 6.7%. The pound had a weak quarter overall, falling 7.3% against the US dollar.
Since the quarter end, however, equity markets have bounced significantly.
Investors’ main concern focuses on inflation and whether central bank tightening will cause the world economy to dip into recession.
Consumer price inflation (% year on year)
Source: Refinitiv Datastream
Inflation jumped in the first half of the year in the UK and the US. Prior to 2022, inflation was already increasing due to the effects of the pandemic (which caused supply shortages) but inflation has risen more sharply this year due to Russia’s invasion of Ukraine, and the subsequent rise in energy and food prices. Inflation impacts consumer confidence, and this, combined with increased borrowing costs for both individuals and businesses, means that a slowdown in growth is unavoidable.
The IMF report shows the expected slowdown across the world economy.
World Economic Outlook Growth Projections (IMF), July 2022 (selected regions & countries)
However, if there is a global recession on the horizon, it is unlikely to be particularly severe. The global economy is still in the process of bouncing back from the effects of lockdown, and certain areas of major economies are still robust, such as employment in US & UK, while others are causing more concern, such as consumer confidence.
Central banks must do everything they can to bring inflation under control in order to restore stability in the financial system and, as such, the Federal Reserve in the US and the Bank of England will continue to tackle this via a combination of higher interest rates and ‘quantitative tightening’ (whereby central banks remove liquidity from the financial system). While headline interest rates continue to make headlines, the decisions central banks need to make to bring their balance sheets down to size are likely to have an even greater effect on the financial system.
In summary, efforts to slow the economy are likely to result in recession (both in the US and UK), although in both cases the underlying economies have so far shown signs of resilience. The sooner central banks can get inflation under control, the sooner the pace of monetary tightening can slow, reducing the risk of a deep recession.
Inflationary pressure is likely to peak in the next few months in the US, UK and Eurozone.
Median of economists’ forecasts for headline inflation (CPI) for US, UK and Eurozone (% change year on year, quarterly average)
Indeed, there have been signs that some elements of inflationary pressure may be softening, as highlighted in the latest Bank of England Monetary Policy Report. The prices of oil, agricultural goods and industrial metals have eased.
Oil, Agricultural goods, and Industrial metals price movements
Sources: Bloomberg Finance L.P., Refinitiv Eikon from LSEG, S&P indices and Bank of England calculations.
Although gas prices have risen sharply and remain a source of concern, particularly in Europe.
International wholesale gas prices
Sources: Bloomberg Finance L.P. and Bank of England calculations.
Inflation and investment strategy
Some inflation can be reasonably good for stock markets, as long as it doesn’t spiral too far out of control. Our investment strategy for protecting against inflation involves combining investment in specific equities together with inflation protected infrastructure projects (including renewables).
1. Equity investments
Firstly, certain companies have strong business models that are relatively insulated from the effects of inflation. Companies with healthy or rather fat margins are able to absorb input price inflation and still maintain a positive margin. A business enjoying a competitive advantage is able to raise prices and their customers will generally not switch to another product. Companies with strong balance sheets, low debt and high cash flows are generally not threatened by rising interest rates. Those that can maintain their dividends in a tough economic environment tend to hold up better when equity markets are under pressure. This is because the dividend yield quickly starts to look like a bargain if the stock price falls.
Secondly, we generally target multinational companies that can grow their market share (by expanding into new regions) regardless of the state of the global economy. Many of these companies were able to make progress as weaker competitors struggled through the pandemic.
Thirdly, as mentioned in previous commentaries, large UK listed companies (most of which are multinational companies) are relatively cheap compared to other major equity markets around the world, especially when compared to the US.
2. Infrastructure investments
In the UK, Europe, and US, a vast number of infrastructure projects are planned, to be put in place now and for several decades to come. These projects, which include investments in renewables, are often government backed and inflation protected. These opportunities represent lower risk investments, to balance the equity strategy, while offering significant protection against inflation.
In summary, our investment approach for dealing with inflation is to combine the equity market strategy mentioned above with investment in infrastructure & renewables.
The economic challenges highlighted above have caused wild swings in financial markets, and we expect a continuation of the tricky market conditions we have seen since the start of the year. However, given that markets have already fallen to reflect the uncertainty driven by inflation and the risk of recession, we are cautiously optimistic for the remainder of the year.
Although this is a time to be exercising caution, we remain disciplined in sticking to our investment philosophy. Our portfolios are well diversified and designed to reduce volatility, with a focus on investing for the long term.
It is worth repeating a phrase which we often return to during periods of uncertainty in the markets ; “Bad companies are destroyed by crises; good companies survive them; great companies are improved by them.”
Our exposure to resilient multinational companies is balanced by investment in renewables and infrastructure, which offer inflation-protected returns in a sector which is due to receive unprecedented levels of investment over the coming decades.