As we finally start to emerge hesitantly from the nuclear bunkers protecting us from Covid-19, where do we go from here? In particular, where should our investments go from here? In this latest edition of our deeply imperfect attempts at predicting the future, we thought we’d put the spotlight on inflation and how that might affect investment returns if it were to rise significantly from the derisory levels that have been enjoyed here in the UK and also the rest of the developed world for the past few years.
Inflation in the UK, like interest rates, has been running at almost zero for the past decade, but it doubled in April as higher energy bills pushed up the cost of living. The Consumer Prices Index (CPI) hit 1.5% the Office for National Statistics (ONS) said, up from 0.7% in March. The rise came after the energy regulator removed the cap on price rises on gas and electricity bills and average prices immediately rose by £96 to £1,138 for 11 million default tariff customers. The increase in the price cap was the biggest factor in the jump in CPI, the ONS said. UK inflation is set to rise further over the months ahead as prices for air travel, domestic accommodation and package holidays leap in response to rebounding consumer demand.
The inflationary picture is much the same in many countries around the world, especially in America. Even Germany with its deep seated, historical aversion to hyperinflation is seeing signs of inflation picking up, with prices there now rising by over 2% compared with 0.37% in 2020. As the global economy emerges from a pandemic-induced lockdown, prices of many goods and services are skyrocketing (perhaps only temporarily, perhaps not), and with some central banks still engaged in quantitative easing, this price pressure is not going to be reversed any time soon.
It doesn’t help that some central banks - including the US Federal Reserve and the Bank of England - are trying to juggle two competing concerns: keeping prices stable and boosting employment. Increasingly, the two aims of this dual mandate are squeezing the deciders of interest rates between a rock and a hard place. After many years of central bank committee members turning up to meetings once a month, enjoying a good lunch and then deciding to keep interest rates unchanged, central banking is becoming really hard again.
As the headline of a recent Bloomberg article succinctly put it, “the world economy is suddenly running low on everything” and prices are going through the roof. The Federal Reserve believes this is a temporary phenomenon driven by pandemic-related shortages and supply-chain disruptions as lockdowns are released. Don’t forget how much of the world’s supplies of cheap clothing, consumer goods, electrical devices etc. are made in China, so any disruption to that producer’s economy or distribution network will have major implications for output. As any first year economics student will tell you, when demand exceeds supply prices are bound to rise.
Surveys suggest businesses believe the problems could persist into next year. And there’s a suspicion that policymakers are partly reluctant to raise rates because they have got an eye on the jobs market. Mass unemployment is not politically possible in today’s social media driven world.
But there is a problem with all this. Central banks like the Bank of England will have to stop printing money in such vast quantities before long as they need to get to a point where it can be reintroduced if we get another economic shock. Even Andrew Bailey, the current Governor of the BoE, realises that. Joe Biden doesn’t, which will prolong the party for a while, but the eventual hangover will be worse. And that’s when the problems will come; when we all start to get back to normal again.
So what are we doing to protect our clients’ hard earned money? Well, first of all you should remember that inflation is caused by companies and individuals putting up their prices. This means that if a company raises its prices by say 5% and is able to restrict increases in its costs of production to 3% then it should make more profit. So a bit of inflation can be beneficial to the stock market.
Secondly, we’ve long believed in diversification to spread your capital between several often contradictory asset classes. In other words not having all your money in shares or bonds or commodities, but rather dividing it between many different types of holdings with the specific plan that not all the funds in your portfolio will rise (or fall) at the same time. We deliberately choose fund managers who have widely differing views on how the world economy will perform over the next few years and which companies and assets will therefore do well or badly. In this way we can’t be completely right, but more importantly we can’t be completely wrong either. For most clients the aim is to be able to generate a return over five years which is significantly higher than inflation or interest rates so that your hard earned money is worth more in real terms in the future than it is today. Returns can’t be guaranteed of course, but we’ve done OK for the past 20 years or so.
In addition, since it’s the stock market that can usually be relied upon to yield the highest long term returns, it is most important that this area is successful for us. Our fund managers avoid short termism and speculation. Over the long term, it’s hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for 40 years, you’re not going to make much different than a 6% return – even if you originally buy it at a huge discount. Conversely, if a business earns 15% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with one heck of a result.
Our research tries to identify funds that will only buy shares in high quality companies (those with strong, durable competitive advantages) that earn above average returns on capital, can deploy more capital, are well managed and available to purchase at reasonable valuations. We then want our managers to be patient; doing nothing well is much better than flurries of activity with little benefit.
In the wake of Covid-19 the policies and stimulus applied by governments and other policy makers has encouraged risk taking across all assets. Liquidity is abundant and interest rates are being artificially depressed by policy makers to relieve any pressure on borrowers and encourage further borrowing. In the midst of all this risk taking we deliberately invest in fund managers who have a track record of delivering solid profits year in and year out. This situation could persist for some time but we continue to believe that, over the long term, the value of any asset will grow in proportion to the growth in its profits. In the short term valuation changes can make a meaningful positive or negative impact but in the long term, it’s the compounding of profits that counts. We don’t fret about this, indeed it has been our experience that the best time to buy shares in companies is when market goes through a period of volatility. This is one of those periods.