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Rapidly rising inflation is a source of global concern, as evidenced by dwindling consumer confidence numbers and the extreme actions of Central Banks around the world. Even the European Central Bank raised rates recently – for the first time in eleven years.
So, it should come as no surprise that Sahil Mahtani, a Strategist at Ninety One’s Investment Institute, flagged inflation as the single biggest issue occupying the minds of researchers at the Institute.
Sahil oversees research, and was interviewed by Nigel Smith, Managing Director of the UK Client Group at Ninety One’s recent Investment Institute Forum.
Nigel had outlined the Institute’s three core pillars of research (strategic asset allocation, structural macro views and cyclical macro views), and asked Sahil to share the Institute’s most strongly held beliefs with regard to each pillar.
In a word, inflation, he responded. “Inflation is profoundly traumatic for society. Just ask people who were investing in the 1970s, or even the 1950s.”
One cannot escape inflation, he explains. It has an impact on strategic asset allocation, making it very challenging for different asset class movements.
Thinking about inflation from a cyclical perspective, he adds that the Institute is of the view that Central Banks have acted decisively after starting the year behind the curve in their bid to control inflation. However, “recession risk is live. Every day the data points are worsening. To generate real growth when inflation is 8%, requires nominal growth ahead of that.”
History is clear. When inflation is above 4% and unemployment below 4%, recession is the result. “Former US Secretary of the Treasury, Larry Summers, made this point, which is unambiguously correct,” he adds.
The Taylor principle then applies – the nominal interest rate must be raised more than one-for-one, in other words to above 9%, to cool the economy.
Sahil told the audience that he does not believe this extreme outcome is likely, but adds that the direction of travel is clear, which is a difficult scenario for growth.
“We believe that the Central Banks will do what is necessary, they are serious about lowering inflation.” He sees this as a ‘Volcker-lite’ scenario, in reference to Paul Volcker’s aggressive, but ultimately successful, actions to bring inflation under control in 1980-81.
Investors will be watching closely. History also shows that inflation levels above 4% almost always lead to a positive bond/equity correlation, which implies that in the world of stocks and bonds when the chips are down, diversification offers little benefit.
However, Sahil had some words of comfort for the assembled investors. Looking at inflation from a structural perspective, on a five to ten year view, research suggests that the world of high inflation may not be as long lasting as many imagine.
Citing The Road to 2030, an extensive piece of macro research led by the Institute, he noted that while rates will rise in the short term, in the longer term there are deep structural forces pushing the world towards disinflation.
These include demographics, technological innovation, and the impact of global supply chains. Demographics and lower productivity will slow growth rates. “Growth is driven by physical capital, human capital and productivity. While physical capital has remained constant, human capital has declined – there are fewer of us in developed markets.”
Compounding this problem is the fact that productivity is not improving.
What are the implications of this changing environment for professional money managers? Don’t assume that what worked in the past will continue to work. “We cannot rely on Beta to drive stock prices.”
Capital market assumptions that have held true for decades, namely that a typical 60/40 portfolio will yield returns above inflation, no longer apply.
Thus, investment managers have choices: reduce the target return; take more risk, which in this environment means adding more equity to the portfolio; or do something different, he says. Dynamic asset allocation is critical. “Buying and holding makes sense when inflation is low and Central Banks are pushing asset prices up. But when higher inflation leads to higher volatility and Central Banks are leaning into inflation, you will have a bumpier asset return profile – so you need dynamic asset allocation.”
Lastly, he advised investment managers to anchor themselves in long-term structural thematics:
“Position yourselves in the right tailwinds and away from the headwinds.”
Themes to watch, he says, include decarbonisation, China’s move up the manufacturing value-chain, and technological disruption.
The views expressed are as at the date of publication and may no longer be current.
Investments involve risk; losses may be made.