Valuation Commentary
18 JULY 2021
At the time of writing, we are approaching ‘Freedom Day’, July 19, after a contentious one month delay. Summer holidays are, again, likely to be disrupted, with holiday destinations having their quarantine criterion changed on a weekly basis. Whatever you choose to do, we wish you a happy summer, safe in the knowledge that society appears to be getting back to normal. Threats of a further lockdown in September are still muted.
For most of our clients, inflation forms the core of their targeted return and, for those where there is another benchmark, it remains an important consideration when we make investment decisions on your behalf. Our most recent asset allocation meeting, in early July, had the subject of inflation as the core topic. One might be forgiven for assuming that this is always the case. In reality, no; while it is discussed, inflation has been (mostly) benign for the years following the great financial crisis. In fact, most of our inflationary discussions have concerned deflation or the ‘Japanification’ of the developed world. Therefore, higher inflation has rightly not been considered a threat, until now. The post-pandemic recovery has proven to be inflationary to the point that some commentators are pointing to the 1970s as a likely outcome. We do not share this belief; in fact, our view is that while inflation will spike, and we may see prints not seen in decades, it will be transitory.
The environment simply does not exist to see a return to the 1970s levels of inflation. Forward guiding independent central banks were not in place in the 1970s and commodities, while displaying some inflation, are not a structural threat. The impact of high levels of debt, weakening demographics, and disruption through technological advances are all very powerful and deflationary. These conditions were not present in the 1970s and the other previous periods of high inflation environments coincided with the great depression and both world wars. Again, the current factors driving inflation are very different. It may be an eyebrow moving moment, but it is worth remembering that US rolling 12-month Inflation from January 1926 - March 2021 was 3.0% on average with this falling to 2.6% on a median basis. US inflation peaked in the mid-1940s at just under 20% and mid-teens in the 1970s, only to fall back sharply.
In our view, structural inflation at or beyond 4% is a real threat, with few asset classes performing, or even defending, well. But the 1-4% range invites an almost Goldilocks environment: not too hot and not too cold. In fact, equities perform best here with fixed income not having too bad a time of it, although it would prefer a low inflation rate environment. We should add that we are currently not in the camp of believing that the negative correlation between equities and bonds will break down, so our multi-asset approach will be maintained, for the most part in its current structure. Central banks will run their economies hot and expect fiscal policies to help bail out structural inefficiencies within economies. It is our view that inflation will print more than 4%, but only for a short period and then fall back. We are yet to achieve internal consensus on whether the new inflationary environment will be slightly higher than we are used to but, if it is, it will be marginal. We should also note that an economic recovery is itself somewhat inflationary.
Anecdotally, ask yourself if your own consumption has changed. If, like many in the nation, you have forgone a holiday, are you likely to have two the following year to make up for that loss? Many have brought forward substantial capital outlays be it a car purchase, extension or new kitchen from next year into this, or even into last year. Again, this level of capital consumption is unlikely to be repeated next year; in effect, future consumption has been brought forward, creating inflation. Supply bottlenecks will be sorted, and supply chains may become much shorter, but until this happens, they will contribute to short term inflation.
A relevant question is what are we doing to manage portfolios in line with this inflation outlook. For the most part, very little as timing the top of the inflation cycle is a coin toss at best, so we are not making that call. Our portfolios are set up for the inflation Goldilocks scenario and, within alternative income, there is substantial inflation protection, which is also true of equities in the 1-4% inflation environment. We have, however, increased the weight to UK equities, where applicable, as this market is still cheap on a relative value basis compared with other developed equity markets. Importantly, UK equities also have a structural bias to those sectors that benefit from an inflationary tailwind (financials and resources by way of examples).
Inflation is an emotive subject and will gather headlines, especially as short term print numbers will be at levels not seen for decades. But it will be short lived.
Portfolios experienced higher than average turnover levels last year and into this, reflecting market changes, but these have fallen and are likely to remain muted for some time.
If you have any questions that we may be able to assist with or would like to update the personal information that we are holding for you, please do get in touch with your usual CAM contact. We would also like to make you aware that we have been experiencing significant delays in dealing with third party providers in recent months. While we are working hard to ensure that the impact to our clients is minimal, if you are likely to need information, income or other input from such a supplier please do factor in extra time when making your request.
James Calder
Research Director
City Asset Management PLC
