Markets are pricing in a goldilocks scenario of subsiding inflation, no recession and lower interest rates, but they couldn’t be more wrong, according to Nick Clay, co-manager of the £330m Redwheel Global Equity Income fund.
To him, investors should start to consider the possibility of higher inflation for longer, as central banks will be incentivised to cut earlier and keep rates lower than they need to be, so that inflation stays high.
Loathed by the masses as it may be, inflation does a lot of good for governments, especially if they’re indebted. In Clay’s words, inflation is “exactly what governments want to get rid of their debts”.
If a country’s GDP can grow faster than its debt mountain, and GDP grows as prices go up, then eventually the debt becomes a smaller part of the economy.
There is a catch, however: central bankers need to play ball and keep interest rates lower than they should be to keep stimulating both growth and fiscal spending.
“We are now about to find out just how independent the Federal Reserve really is. My cynical view is that not many central banks around the world are genuinely independent. They are all funded by governments after all,” Clay said.
“There is a higher probability that rates will be lower than they really should be because of the pressure that's brought to bear on central banks by their governments, because they desperately need that stimulus.”
This is what happened after World War II, Clay explained, when economies entered decades of massive inflation precisely to get rid of their debts.
Today, public debt has crept into the conversation and into investors’ minds multiple times in the past few years, including after Liz Truss’ mini-Budget and after the raising of the US debt ceiling.
Edmund Harriss, chief investment officer at Guinness Global Investors, told Trustnet that US debt is at “critical levels” and something needs to happen soon to avoid global repercussions.
In theory, there is an alternative – to stop spending and go into austerity. But that is very painful and might burn the chances of re-election. Which is the reason why today, governments across the globe seem to have made up their minds about inflation.
US policies are all about tax less, spend more. In the UK it is tax more, spend more, Clay noted. In both cases, it is all about spending more, which tends to lead to inflation.
The result will be that rather than slipping into a recession as rates are forced to stay higher for longer, the more likely scenario is a return of inflation.
“And yet no one is thinking about that in the way they are investing,” he said.
When it comes to portfolio construction, the main point the manager wanted to get across is that inflation doesn’t just arrive and stay high, it goes in waves, and it's the waves of inflation that generate volatility.
“This is when valuations will matter again, as volatility causes problems particularly for companies with high valuations,” he said.
“A high valuation on a stock is the market demanding a certain amount of perfection from that company, but even the best companies in the world, when things get volatile, can't deliver on expectations if they are too high.”
In a period of heightened inflation such as the Seventies, two equity sectors worked well – deep value and income (although equities weren’t the best-performing asset class, coming below cash and government bonds).
“Dividend growth during the 1970s was able to keep up with inflation, which made income investors able to withstand inflation in real terms,” Clay said.
Therefore today, he would look at companies with pricing power and the ability to continue their dividends.
In particular, the manager identified three areas where companies have the ability to put up prices in an inflationary environment: companies that sell things people have to buy; things that are a legal requirement, such as insurance; and companies that work in an environment where regulators allow them to put up their prices, such as utilities.
As of today, the Redwheel Global Equity Income fund’s highest sector exposure is consumer products (31.3%), followed by telecom, media and technology (16.7%), and healthcare (12.9%).