Investment Insight | The return of inflation
As the world recovers from the pandemic and economies reopen, inflation is rising at accelerating levels.
Inflation is expected to reach levels not seen for over 35 years which is having a significant impact on the investment landscape and potential returns. In this Investment Insight we look at why inflation is occurring, why it is important from an economic standpoint and how we are positioning our portfolios to benefit from this inflationary environment.
What are the current inflation levels and what is causing it?
In May, the reported United States Consumer Price Index (CPI) number was 5.0% (year on year) which is the highest level seen since 2008. Perhaps more startling is a measure followed closely by the United States Federal Reserve called ‘Core Inflation’, which removes the impact of more volatile food and energy prices. May showed a 0.7% month-on-month increase, or 8.4% on an annualised basis which is the highest level seen since the early 1980s when developed markets around the world saw inflation levels up to 15% per annum.
This increase in inflation is being driven by a number of factors that are all linked to COVID-19. First, global central banks, in particular the United States, have printed a huge amount of money to help ease financial conditions and stimulate the economy (often referred to as ‘quantitative easing’). In addition, there has been a significant increase in government spending which has come at the same time as economies are reopening. This has created a fast rebound in economic activity and growth.
Inflation is also being caused by supply constraints and higher costs. The pandemic has led to various disruptions in how the global economy produces and trades goods. This has meant capacity constraints and delivery delays in a vast array of raw materials and finished goods. This leads to a further widening in the demand to supply gap, which again causes higher prices and inflation.
Why does inflation matter?
Inflation, as is most commonly measured through rises in the CPI, is a broad reflection of the cost of living for the typical consumer. If CPI is rising, and this is not offset through an increase in the wages earned by the consumer, then the affordability of their lifestyle decreases, and that consumer will need to either reduce spending or cut the amount they save.
From a broader economic perspective, prevalent economic theory indicates that a modest amount of inflation in the range of 1% – 3% is optimal for sustained economic growth. However, if inflation materially exceeds this level on a sustained basis, this can lead to adverse consequences such as a reduction of the local currencies purchasing power, higher unemployment, increasing wealth inequality and ultimately lower economic growth in real terms (adjusted for inflation). For this reason, when inflation begins to run too high, governments and in particular their central banks look to reduce it.
The primary method central banks have for containing inflation is through the increase of interest rates. Raising the cost of borrowing has the consequence of decreasing the amount of money that is lent out (when it costs more to borrow, you borrow less). This decreases the amount of money in circulation in an economy and ultimately means consumers spend less. When consumers spend less, prices typically go down and therefore inflation reduces. Rising interest rates then have a profound impact on all aspects of the economy from housing prices to business growth.
In summary - increases and decreases in inflation are central to the economic cycle and have broad and significant consequences for the investment landscape.
How does inflation change the investment landscape?
The returns in various asset classes and the earnings potential of different businesses can change significantly between low inflation and high inflation environments. This has implications for investors in how they allocate towards shares, bonds and property, but also to what individual companies you should invest in.
From a bond perspective, let’s look at a quick example of how inflation would cause you to sell a bond. In an inflation environment of 2% per annum it would make sense to own a bond paying a fixed return of 4% per annum, as you are still making a 2% return after factoring in the 2% you lose from inflation. However, what if annual inflation increased to 5%? When your bond is paying 4% per annum you are making a 1% loss from this bond each year!
Over time, the return demanded by bond investors would increase so they still make the same 2% return after inflation. This can come in the form of increasing the yield on a bond. For the yield to increase the price of the bond must decrease. This can take time. In the interim, it would make sense to sell this bond and invest in something that protects the value of your investment by at least the 5% level of inflation. This could mean investing a higher proportion of your money in riskier assets such as shares.
From a share investment perspective, we need to consider the types of businesses we are investing in. Some companies are able to perform better than others in a higher inflation environment so you want to weight your portfolio to these companies. Typically, as inflation rises, you see the cost of the products or services of these businesses rise (e.g. the raw materials or the wages they need to pay employees). Businesses that sell products or services where they are able to pass on these cost increases will be able to protect their profit margin and maintain their level of earnings. However, businesses that cannot pass through these cost increases will suffer margin pressure and declining earnings.
Typical companies that can pass through cost increases are ones that have high market shares and brand strength (e.g. Apple) or businesses that sell essential goods that consumers cannot be without (e.g. agriculture, energy, core materials). Businesses that are at the start of the supply chain, like miners, are often able to receive the benefits from selling their products at higher prices but without materially higher costs so their profit margins can actually increase. Commodity prices tend to rise significantly in inflationary environments so, in general, businesses that sell commodities do well. Banks perform well in rising interest rate environments as they lend at higher rates and are still funded at relatively lower interest rates. Interest rate rises tend to follow inflation rises, so it is a good environment to buy banks.
How are we positioning portfolios to perform in an inflationary environment?
We have dedicated a significant amount of time to understanding the impacts of inflation and studying historical periods to observe how different investments perform in inflationary environments. This work has led to the following key trades that we have positioned our portfolios to benefit from.
Short United States government bonds. As inflation rises and the United States Fed is forced to respond through increasing interest rates, the yield on United States government will increase which means the price of these bonds falls. Put simply, we make positive returns when United States interests rates rise.
Commodities exposure. Commodities are one of the most consistent and high returning asset classes in high inflation environments. We have positions in commodities such as aluminium and carbon credits.
Stock picking. The shares in our portfolio are overweight in sectors and companies that are more likely to benefit in an inflationary environment. This includes commodity producers, agricultural companies, banks and certain industrial companies.
Crypto exposure. High inflation reduces the value of each dollar you own. This increases the relative attractiveness of cryptocurrencies and therefore we consider this a good environment to hold store of wealth cryptocurrencies like Bitcoin.
As always, we manage these positions actively and change allocation accordingly if our view on inflation or the speed in which it is occurring changes.
Inflation is expected to reach levels not seen for over 35 years which is having a significant impact on the investment landscape and potential returns. In this Investment Insight we look at why inflation is occurring, why it is important from an economic standpoint and how we are positioning our portfolios to benefit from this inflationary environment.
What are the current inflation levels and what is causing it?
In May, the reported United States Consumer Price Index (CPI) number was 5.0% (year on year) which is the highest level seen since 2008. Perhaps more startling is a measure followed closely by the United States Federal Reserve called ‘Core Inflation’, which removes the impact of more volatile food and energy prices. May showed a 0.7% month-on-month increase, or 8.4% on an annualised basis which is the highest level seen since the early 1980s when developed markets around the world saw inflation levels up to 15% per annum.
This increase in inflation is being driven by a number of factors that are all linked to COVID-19. First, global central banks, in particular the United States, have printed a huge amount of money to help ease financial conditions and stimulate the economy (often referred to as ‘quantitative easing’). In addition, there has been a significant increase in government spending which has come at the same time as economies are reopening. This has created a fast rebound in economic activity and growth.
Inflation is also being caused by supply constraints and higher costs. The pandemic has led to various disruptions in how the global economy produces and trades goods. This has meant capacity constraints and delivery delays in a vast array of raw materials and finished goods. This leads to a further widening in the demand to supply gap, which again causes higher prices and inflation.
Why does inflation matter?
Inflation, as is most commonly measured through rises in the CPI, is a broad reflection of the cost of living for the typical consumer. If CPI is rising, and this is not offset through an increase in the wages earned by the consumer, then the affordability of their lifestyle decreases, and that consumer will need to either reduce spending or cut the amount they save.
From a broader economic perspective, prevalent economic theory indicates that a modest amount of inflation in the range of 1% – 3% is optimal for sustained economic growth. However, if inflation materially exceeds this level on a sustained basis, this can lead to adverse consequences such as a reduction of the local currencies purchasing power, higher unemployment, increasing wealth inequality and ultimately lower economic growth in real terms (adjusted for inflation). For this reason, when inflation begins to run too high, governments and in particular their central banks look to reduce it.
The primary method central banks have for containing inflation is through the increase of interest rates. Raising the cost of borrowing has the consequence of decreasing the amount of money that is lent out (when it costs more to borrow, you borrow less). This decreases the amount of money in circulation in an economy and ultimately means consumers spend less. When consumers spend less, prices typically go down and therefore inflation reduces. Rising interest rates then have a profound impact on all aspects of the economy from housing prices to business growth.
In summary - increases and decreases in inflation are central to the economic cycle and have broad and significant consequences for the investment landscape.
How does inflation change the investment landscape?
The returns in various asset classes and the earnings potential of different businesses can change significantly between low inflation and high inflation environments. This has implications for investors in how they allocate towards shares, bonds and property, but also to what individual companies you should invest in.
From a bond perspective, let’s look at a quick example of how inflation would cause you to sell a bond. In an inflation environment of 2% per annum it would make sense to own a bond paying a fixed return of 4% per annum, as you are still making a 2% return after factoring in the 2% you lose from inflation. However, what if annual inflation increased to 5%? When your bond is paying 4% per annum you are making a 1% loss from this bond each year!
Over time, the return demanded by bond investors would increase so they still make the same 2% return after inflation. This can come in the form of increasing the yield on a bond. For the yield to increase the price of the bond must decrease. This can take time. In the interim, it would make sense to sell this bond and invest in something that protects the value of your investment by at least the 5% level of inflation. This could mean investing a higher proportion of your money in riskier assets such as shares.
From a share investment perspective, we need to consider the types of businesses we are investing in. Some companies are able to perform better than others in a higher inflation environment so you want to weight your portfolio to these companies. Typically, as inflation rises, you see the cost of the products or services of these businesses rise (e.g. the raw materials or the wages they need to pay employees). Businesses that sell products or services where they are able to pass on these cost increases will be able to protect their profit margin and maintain their level of earnings. However, businesses that cannot pass through these cost increases will suffer margin pressure and declining earnings.
Typical companies that can pass through cost increases are ones that have high market shares and brand strength (e.g. Apple) or businesses that sell essential goods that consumers cannot be without (e.g. agriculture, energy, core materials). Businesses that are at the start of the supply chain, like miners, are often able to receive the benefits from selling their products at higher prices but without materially higher costs so their profit margins can actually increase. Commodity prices tend to rise significantly in inflationary environments so, in general, businesses that sell commodities do well. Banks perform well in rising interest rate environments as they lend at higher rates and are still funded at relatively lower interest rates. Interest rate rises tend to follow inflation rises, so it is a good environment to buy banks.
How are we positioning portfolios to perform in an inflationary environment?
We have dedicated a significant amount of time to understanding the impacts of inflation and studying historical periods to observe how different investments perform in inflationary environments. This work has led to the following key trades that we have positioned our portfolios to benefit from.
Short United States government bonds. As inflation rises and the United States Fed is forced to respond through increasing interest rates, the yield on United States government will increase which means the price of these bonds falls. Put simply, we make positive returns when United States interests rates rise.
Commodities exposure. Commodities are one of the most consistent and high returning asset classes in high inflation environments. We have positions in commodities such as aluminium and carbon credits.
Stock picking. The shares in our portfolio are overweight in sectors and companies that are more likely to benefit in an inflationary environment. This includes commodity producers, agricultural companies, banks and certain industrial companies.
Crypto exposure. High inflation reduces the value of each dollar you own. This increases the relative attractiveness of cryptocurrencies and therefore we consider this a good environment to hold store of wealth cryptocurrencies like Bitcoin.
As always, we manage these positions actively and change allocation accordingly if our view on inflation or the speed in which it is occurring changes.
Source: Bloomberg.
Source: Bloomberg. * US Personal Consumption Expenditure Core Price Index MoM.
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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Andrew Curtayne is Senior Portfolio Manager for New Zealand Funds Management Limited (NZ Funds) and a member of the NZ Funds KiwiSaver Scheme. Andrew's 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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