It’s all about inflation

30th September 2022

Inflation is the single most important issue occupying the minds of investment strategists, writes Sahil Mahtani, a Strategist at Ninety One’s Investment Institute

At a glance

  • Inflation is one of the single biggest issues occupying the minds of researchers at Ninety One
  • Central banks are serious about lowering inflation
  • Investors have a number of choices

Rapidly rising inflation is a source of global concern, as evidenced by dwindling consumer confidence numbers and the actions of Central Banks around the world. For the first time in 11 years, the European Central Bank has begun raising rates this year, while the US Federal Reserve has repeatedly increased its rates by 0.75%.

So, it should come as no surprise that inflation is one of the single biggest issues occupying the minds of researchers at the Ninety-One Investment Institute.

Inflation can be profoundly traumatic for society—and for portfolios. Just ask people who were investing in the 1970s, or even the 1950s.

The role of central banks

We are of the view that central banks have acted decisively after starting the year behind the curve in their bid to control inflation. However, the risk of recession is alive. Every day the data points are worsening. In part this is optical--to generate real growth when inflation is 8% requires nominal growth ahead of that.

History is clear. When inflation is above 4% and unemployment below 4%, recession is the result. Former US Secretary of the Treasury, Larry Summers, made this point, which is unambiguously correct.

In monetary policy, there exists the ‘Taylor principle’ which argues that interest rates must be raised more than one-for-one with inflation, in order to stabilize it. According to this rule, the UK interest rate would need to break 10% in order cool the economy.

Although we do not believe this extreme outcome is likely, the direction of travel is clear, which is a difficult scenario for growth. In other words, as Fed chair Powell has argued, a period of below trend growth is necessary in order to bring inflation down.

We believe that the central banks will do what is necessary. They are serious about lowering inflation.

Paul Volcker was the Chair of the US Federal Reserve in the 1980s, when the Fed took aggressive, but ultimately successful actions to bring inflation under control through two short recessions in 1980-81. Arguably markets are finally taking seriously what might be described as a ‘Volcker-lite’ scenario.

Asset allocation

Investors will be watching closely. In recent history, with the exception of the 1970s, bonds and equities have had what is known as a ‘negative correlation’ – that is to say when one goes down, the other generally goes up. This has meant portfolios have been able to mitigate some of the volatility in the stock markets by diversifying into bonds.

However, history also shows that inflation levels above 4% almost always lead to a positive bond/equity correlation, which implies that in the world of stocks and bonds when the chips are down, diversification is more challenging, and investors need a different approach.

While this might all appear negative, there are a few reasons to take comfort. Looking at inflation from a structural perspective, on a five-to-ten-year view, research suggests that the world of high inflation may not be as long lasting as many imagine.

According to The Road to 2030, an extensive piece of macro research led by the Institute, while rates will rise in the short term, in the longer term there are deep structural forces pushing the world towards disinflation.

These include demographics, the level of accumulated debt, and technological innovation, Demographics and lower productivity will continue to put pressure on growth rates.

What are the implications of this changing environment? Don’t assume that what worked in the past will continue to work.

Assumptions that have held true for decades, namely that a typical 60% equity/40% bond portfolio will generally yield returns above inflation, need to be tested given current levels of inflation and the high starting valuations.

Thus, investors have a number of choices: reduce the target return; take more risk, which in this environment means adding more equity to the portfolio; or do something different.

What must investors do differently? They need to adopt dynamic asset allocation strategies rather than static allocations, and they need to anchor themselves in long-term structural themes – in other words position ourselves in the right tailwinds and away from the headwinds.

Themes we are watching include decarbonisation, Asia’s move up the manufacturing value-chain, and continued technological disruption in a number of areas.

The opinions expressed are those of Sahil Mahtani and are subject to market or economic changes. This material is not a recommendation, or intended to be relied upon as a forecast, research, or advice. The views are not necessarily shared by other investment managers or St. James's Place.

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