Please see article below from Artemis, received yesterday afternoon – 25/02/2021
Do equities protect investors from inflation?
Economists are divided over what comes next for inflation. Simon Edelsten assesses the threat of inflation in the East versus the West. He explains why investing in strong companies with high margins may reduce capital risk, should inflation overshoot.
In the past decade, inflation has grown by a compound rate of just 1.8% a year. By comparison, measured in sterling, global equities have risen by 177% – an impressive 10.8% a year.
It might surprise those whose faith lies purely in bricks and mortar that the average UK house price rose by just 30-40%, depending on which index you use, during the same period. That is equivalent to an annual rate of around 3%.These low levels of inflation have surprised monetarist economists who predicted sharp rises after the introduction of quantitative easing in 2008. According to Milton Friedman’s theory: ‘Inflation is always and everywhere a monetary phenomenon.’ So this expansion of money supply should have caused inflation. It clearly did not.
Today economists are once again raising the alarm. Money supply growth in the US is now twice what it was in the aftermath of the global financial crisis. And now the new Democrat administration has proposed a stimulus package of a further $1.9tn (£1.4tn). Meanwhile, regulators are encouraging looser bank lending, and the Federal Reserve has moved from a target of capping inflation at 2% to ‘average inflation targeting’ – in other words, it will now let inflation rise further before it raises interest rates.
What next for inflation?
Economists are divided over what comes next. Many have reverted to Keynesian-type discussions about supply constraints. They note that China no longer has an abundant, inexpensive labour supply and is falling under the lengthening shadow of the one-child policy that ran from 1980 to 2015. That might point to wage inflation, but we are currently seeing higher levels of unemployment in the West, so that seems unlikely.
Rates offered on government bonds also seem far too low to suggest a sharp spike in inflation is imminent – the UK 10-year bond currently yields 0.28%, and CPI inflation for 2020 was just 0.8%.
However, some cynical souls warn that western governments have a vested interest in letting inflation loose. It is the only way they can rid themselves of the debt they have built.
In the circumstances, taking measures to protect one’s savings and investments against an unexpected rise in inflation seems prudent. That is not a forecast of high inflation – we have seen too many of those prove wrong. Rather, it is recognition that the risks of this threat to wealth have risen.
Lessons from history
As equities give stakes in the real economy, they have long been seen as a way to protect savers from inflation. This theory was at its height in 1972. Over the succeeding three years inflation rose to an eye-watering peak of 24%. And equities? The UK equity market fell 73% between May 1972 and December 1974. The charts then show markets recovering, but in real terms these rises amounted to little. Cost-of-living rises above 20% a year and punitive capital gains taxes took their toll.
The inflation of the early 1970s was caused by the US taking the dollar off the gold standard and by the sharp rise in oil prices – rather different threats to those likely today. All the same, lessons from history on which sectors fared well and badly may be useful.
The 1970s market started from much higher valuations than we see today – perhaps a result of overconfidence in the ability of equities to cope with inflation. Some sources quote the then FT30 index traded at 19 times earnings compared with the FTSE 100’s forecast price-earnings (P/E) multiple today of 15.5.
In those days the index was made up of companies with rather less international exposure and often rather more debt. Inflation drove lending rates higher, leaving banks and property companies worst affected. As their loans matured, companies were forced to refinance at much higher interest rates.
Today’s equity market is notably different in how well-financed and internationally successful our larger companies have become. They have generally reduced their debt exposure since 2008, and many have much greater power to pass on cost increases than in the 1970s.
In the 1970s equity market the best shares to hold were oil companies (which benefited from the creation of the Opec cartel) and, in the latter part of the decade, nickel miners. These enjoyed the recovery combined with supply restrictions from environmental rules introduced by Jimmy Carter. Similarly, today we would argue that only the world’s largest industrial mining companies are keeping up with increasing environmental regulation and able to invest in automation to improve productivity.
It is also striking that some of the best – or least bad – equities to hold through the 1970s were technology companies, such as Racal. Even though markets may have valued future earnings less highly (given the way the cost of living was expected to rise while you waited), companies that produced very high revenue growth and high margins delivered acceptable returns. Racal rose from 137p and a P/E of 11.7 in 1974 to 208p and 17.5 P/E at the end of 1976.
History suggests that ‘growth’ stocks with good pricing power can do well as inflation rises and that many ‘value’ stocks, such as banks and property, may not – the converse of some current recommendations.
The strong response
We always favour companies with high barriers to entry. These should give a company pricing power, whether inflation comes or not. We also avoid companies with large amounts of debt (rising cost of debt often causes the most trouble in times of inflation). Our selection process also tends to favour companies with high margins – therefore companies that will generally cope well with higher labour costs or increases in the cost of raw materials.
Such investments have performed well over the past 10 years. They may lack the cyclicality the market currently prefers as economies recover, but longer term such strong companies will benefit as much as others from the more normal economic prospects ahead. As we stand, it seems likely that 2021 will be an easier year in which to manage a business than 2020. However, as we were reminded last year, predictions are vulnerable to the unexpected.
Governments have very large stimulus packages prepared and would prefer to prioritise creating work and income over worrying much about inflation.
As asset managers, we must capitalise on the growth opportunities but be alert to the risk of inflation. We believe a balance of strong companies, diversified globally and across different sectors, should reduce capital risk. We will know if it works only if inflation does overshoot. We hope it does not, but it is best to be prepared.
Please continue to check back for our latest updates and blog posts.
Charlotte Ennis
26/02/2021