Investment Insight | Reflation and inflation
Inflation. Deflation. Disinflation. Financial markets are garbled with so many ‘flations these days. As we enter the last quarter of 2020, a term not discussed since 2002 has re-emerged: Reflation. This refers to government efforts to pump up - or reflate - an economy by flooding it with money. Although reflation is not the same as inflation, it can spark inflation.
When the spread of Covid-19 sent global markets into meltdown in March, investors quickly priced in a deflationary shock in the world’s large economies. The severity of the hit to demand became clear as countries, including New Zealand, went into lockdown. However, inflation expectations quickly rebounded, driven by government and central bank stimulus on a scale not seen before.
Fast forward to today and there is a growing polarisation among investors - the fear, simultaneously, of both inflationary and deflationary forces in the economy. We have all these deflationary forces developing - unemployment, demand destruction, over capacity, technology. How can we be talking about inflation being a problem?
The government, central banks and investors are largely willing to accept the possibility of meaningful inflation if it means saving the economy from a recession. The good news is that inflation is often reflective of strong economic demand. Demand-sensitive stocks like those in the consumer discretionary, industrials, materials and energy sectors may outperform. As interest rates rise, banks will also benefit.
Cyclical upswing
In 07 August 2020 | Performance Update we summarised our views around increasing inflation expectations. We had already commenced positioning clients’ portfolios to benefit from a cyclical upswing catalysed by expectations of the development of a vaccine. Since the start of August, global sharemarkets have increased over 6.0%. NZ Funds clients fully participated in this continued momentum of share markets with NZ Funds KiwiSaver Growth Strategy up over 7.2% for the month and 7.8% year to date.
We have also communicated throughout the year that gold was best placed to take advantage of the inflation themes we have discussed. This proved successful, generating strong returns for clients as gold increased almost 30% year to date. Given gold’s strong performance, we took profit and exited our clients’ gold position at around US$2,000/oz.
Exiting clients’ gold position is not to say the reflation/inflation theme is over. We have further increased clients’ exposure to cyclical companies which should benefit from a broader market recovery. We continue to believe it is real assets - by that, we mean things you cannot print - that will benefit from the current environment. This includes real estate and gold, but also alternative assets such as Bitcoin, in which we have taken a modest position.
The asset class to avoid at the moment is cash. We set out our views on cash in 08 May 2020 | Cash is not king . While the absolute level of inflation may be modest, say 2-3%, in an environment of low interest rates the after-tax returns from cash and term deposits will have a significant wealth impact for investors, especially those that have not provisioned for retirement with an investment portfolio of real assets.
Bitcoin and curiosity
Legendary investor Paul Tudor Jones noted in his most recent investor letter “own the best performer and [do] not get wed to the intellectual side that might leave you weeping in the performance dust because you thought you were smarter than the market". Jones was referring to Bitcoin. While Bitcoin is not a traditional asset class, investor nervousness comes from a lack of understanding rather than Bitcoin not being investable.
This is not an excuse to not be curious. We do intense research to understand new asset classes, and invest if the investment regime dictates it. To simply write off an opportunity due to a lack of understanding is intellectually lazy. Imagine if Steve Jobs listened to the naysayers who said you cannot have music and mobile all in one!
In an environment where the investment regime is ever changing, having an active approach with the intensity to continually develop investment ideas, like the examples we have described here, will more likely provide strong absolute returns no matter what direction the share market trades. What turns a ‘good’ investment manager into a ‘great’ investment manager is having a pipeline of positions, themes, sectors, opportunities, as well as the curiosity.
When the spread of Covid-19 sent global markets into meltdown in March, investors quickly priced in a deflationary shock in the world’s large economies. The severity of the hit to demand became clear as countries, including New Zealand, went into lockdown. However, inflation expectations quickly rebounded, driven by government and central bank stimulus on a scale not seen before.
Fast forward to today and there is a growing polarisation among investors - the fear, simultaneously, of both inflationary and deflationary forces in the economy. We have all these deflationary forces developing - unemployment, demand destruction, over capacity, technology. How can we be talking about inflation being a problem?
The government, central banks and investors are largely willing to accept the possibility of meaningful inflation if it means saving the economy from a recession. The good news is that inflation is often reflective of strong economic demand. Demand-sensitive stocks like those in the consumer discretionary, industrials, materials and energy sectors may outperform. As interest rates rise, banks will also benefit.
Cyclical upswing
In 07 August 2020 | Performance Update we summarised our views around increasing inflation expectations. We had already commenced positioning clients’ portfolios to benefit from a cyclical upswing catalysed by expectations of the development of a vaccine. Since the start of August, global sharemarkets have increased over 6.0%. NZ Funds clients fully participated in this continued momentum of share markets with NZ Funds KiwiSaver Growth Strategy up over 7.2% for the month and 7.8% year to date.
We have also communicated throughout the year that gold was best placed to take advantage of the inflation themes we have discussed. This proved successful, generating strong returns for clients as gold increased almost 30% year to date. Given gold’s strong performance, we took profit and exited our clients’ gold position at around US$2,000/oz.
Exiting clients’ gold position is not to say the reflation/inflation theme is over. We have further increased clients’ exposure to cyclical companies which should benefit from a broader market recovery. We continue to believe it is real assets - by that, we mean things you cannot print - that will benefit from the current environment. This includes real estate and gold, but also alternative assets such as Bitcoin, in which we have taken a modest position.
The asset class to avoid at the moment is cash. We set out our views on cash in 08 May 2020 | Cash is not king . While the absolute level of inflation may be modest, say 2-3%, in an environment of low interest rates the after-tax returns from cash and term deposits will have a significant wealth impact for investors, especially those that have not provisioned for retirement with an investment portfolio of real assets.
Bitcoin and curiosity
Legendary investor Paul Tudor Jones noted in his most recent investor letter “own the best performer and [do] not get wed to the intellectual side that might leave you weeping in the performance dust because you thought you were smarter than the market". Jones was referring to Bitcoin. While Bitcoin is not a traditional asset class, investor nervousness comes from a lack of understanding rather than Bitcoin not being investable.
This is not an excuse to not be curious. We do intense research to understand new asset classes, and invest if the investment regime dictates it. To simply write off an opportunity due to a lack of understanding is intellectually lazy. Imagine if Steve Jobs listened to the naysayers who said you cannot have music and mobile all in one!
In an environment where the investment regime is ever changing, having an active approach with the intensity to continually develop investment ideas, like the examples we have described here, will more likely provide strong absolute returns no matter what direction the share market trades. What turns a ‘good’ investment manager into a ‘great’ investment manager is having a pipeline of positions, themes, sectors, opportunities, as well as the curiosity.
Source: Bloomberg.
For more information please contact NZ Funds.
This document has been provided for information purposes only. The content of this document is not intended as a substitute for specific professional advice on investments, financial planning or any other matter.
While the information provided in this document is stated accurately to the best of our knowledge and belief, New Zealand Funds Management Limited, its directors, employees and related parties accept no liability or responsibility for any loss, damage, claim or expense suffered or incurred by any party as a result of reliance on the information provided and opinions expressed except as required by law.
For more information please contact NZ Funds.
This document has been provided for information purposes only. The content of this document is not intended as a substitute for specific professional advice on investments, financial planning or any other matter.
While the information provided in this document is stated accurately to the best of our knowledge and belief, New Zealand Funds Management Limited, its directors, employees and related parties accept no liability or responsibility for any loss, damage, claim or expense suffered or incurred by any party as a result of reliance on the information provided and opinions expressed except as required by law.
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James Grigor is Chief Investment Officer for New Zealand Funds Management Limited (NZ Funds) and a member of the NZ Funds KiwiSaver Scheme. James' comments are of a general nature, and he is not responsible for any loss that any reader may suffer from following it.
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