Investment managers position for post-Covid prospect of inflation return
Investment managers have begun repositioning themselves for the possible return of rising inflation, as world economies respond to fiscal stimulus packages and looser monetary policy put in place by governments and central banks.
Inflation has fallen for the last few months across Europe and US, as the coronavirus pandemic caused nationwide lockdowns and disrupted supply and demand, and has been at historically low levels for years.
In UK, the inflation-tracking consumer price index sank to a four-year low of 0.8 per cent in April, with a further fall expected when the inflation figure for May 2020 is published later this week.
“Any demand shock is in the short term deflationary, and in this regard Covid-19 is no different. How the balance of supply and demand evolve over the coming months and years is more complex and harder to predict,” says Peter Spiller, manager of Capital Gearing Trust, speaking to Association of Investment Companies (AIC).
Spiller is one of the longest-serving managers in the investment trust space, having headed up the Capital Gearing Trust since the start of 1982. He says that currently, companies and consumers are choosing to save rather than spend or invest money, which he describes as a “natural psychological reaction to these tumultuous events”.
Governments have already stepped in to fill the demand gap with various stimulus measures, such as furlough schemes and direct market interventions, and there will likely be more to come.
When policymakers combine low interest rates with pumping new money into an economy that is not growing, this is likely to create inflation in the long term.
Spiller sees this as no bad thing. “Most important of all is the need for inflation. Once the crisis abates public debt will be at levels not seen since the Second World War. The solution to such problems will be the same now as then: financial repression, a prolonged period of low interest rates and elevated inflation. The tools available to governments and central banks are the same as then, we cannot see the outcome being any different.”
Inflation-linked bonds, which typically produce stable but low yields, are expected to be one of the biggest beneficiaries of these policies.
“The best performing asset class in this environment is likely to be index-linked bonds. We favour US TIPS, but also hold index-linked bonds in Japan, Sweden and Australia,” says Spiller.
He adds that “gold could do well too”, as may long-lease properties that offer secure cashflow.
Hamish Baillie, manager of Ruffer Investment Company, echoed this view, speaking about his fund’s positioning: “What don’t we own? Conventional bonds, cash other than for short-term tactical reasons, and a large exposure to equities. What do we own? Government backed inflation-linked bonds in the UK and US, gold, and a low weighting to equities.”
London Stock Exchange-traded Ruffer Investment Company typically invests in a combination of growth assets, usually equities, to take advantage of boom times in the market, as well as protective assets, usually bonds, to make it a “good all-weather investor”.
“Very high inflation, perhaps triggered by excess public spending, is a challenge for equity and bond investors so we have a modest allocation to gold mines in the fund which should offset part of this risk to capital value if it arises,” says Simon Edelsten, fund manager of Mid Wynd International Investment Trust. “We do not expect it to happen, but we are prepared just in case.”
Not everyone is convinced that inflationary times will return post-Covid. Charles Luke, manager of UK equities investment company, Murray Income Trust, says: “The pandemic will impact the UK and global economy in a myriad of areas, but higher inflation is unlikely. In fact, just like in the aftermath of the global financial crisis the risk is more of a disinflationary threat.”
As unemployment rises and demand stays weak, the supply of goods could resume at the same pace as before, thanks to stimulus from central banks and governments. If demand lags supply, prices will fall through the floor and deflation will become the new normal.
“Any pockets of price pressures that may have built up from supply constraints will be more than offset by weak demand. Rising unemployment and the likely staggered recovery in consumption will weigh heavily on the outlook for wage and price growth. Fiscal and monetary policy stimulus should help cap some of these disinflationary forces, but is unlikely to fuel inflationary pressures over the next two years,” adds Luke.
Walter Price, portfolio manager of tech equities investor Allianz Technology, agrees, predicting that inflation will stay low for the next year, while the unemployment rate could grow to as much as 20 per cent.
In this scenario of low inflation or even deflation, defensive stocks would typically include growth companies, especially in technology, which may continue to command higher prices for their goods thanks to new innovations.
Luke says Murray Income Trust’s portfolio has been aligned with those that he sees benefitting from low inflation, including limited exposure to banks that would benefit from higher interest rates, and pharmaceuticals and consumer goods companies, such as AstraZeneca and Diageo.
Edelsten, adds that his Mid Wynd fund is investing in companies which have “very strong market positions and which, therefore, tend to be able to raise prices when there is modest inflation or deflation”, such as scientific equipment maker Thermo Fisher, as good defensive stocks to own against macroeconomic headwinds.
As investment companies make bets about an economic recovery, how this happens will be shaped by the long-term effects of Covid-19, which are still too early to tell.