Feb 8, 2021
The continued absence of inflation has caused consternation in some investing circles. Indeed, one of the investment lessons of the last decade is that it is not sufficient for a fund manager to desire prices to rise for them to do so. In the Ninety One Value team, we are pretty agnostic on inflation – in the sense that we don’t know when it will occur. But this is not to say we are indifferent, because value stocks generally perform well with inflation. We know which side our bread is buttered.
The link between value investing and inflation has become a hot topic again. With the pandemic forcing nearly all governments to implement massive fiscal and monetary stimulus, some investors believe that the price stability of the last decade might be ending, leading them to wonder if they should shift some of their equity allocation to value. However, investing to benefit from inflation is tricky: if prices fail to rise, a portfolio constructed explicitly to benefit from them doing so will suffer.
To help us frame inflation expectations, we enlisted Ninety One’s Multi-Asset team (the requirements of brevity prevent us from reproducing here the entirety of their work on this topic, but we will happily direct interested readers to the team for a more exhaustive presentation). A key point our colleagues highlight is that, even for the pros, inflation is difficult to forecast. In a recent speech1, the European Central Bank’s Chief Economist Philip Lane showed a chart depicting the average contribution of various factors to the level of inflation across some 600 economic models. Other than ‘economic slack’, pretty much the only other large predictor of core inflation is the ‘unexplained’ factor, i.e., the error term. This suggests that the ECB does not have a good working model of inflation.
Daniel Tarullo, an ex-member of the US Federal Open Market Committee, recently came to a similar realisation: “After eight years at the Fed, my conclusion was that there is no well-elaborated empirically grounded theory that explains contemporary inflation dynamics in a way useful to real-time policymaking.”
This obviously has worrying implications for a central bank specifically mandated to target inflation (like the ECB). But it also drives home that any inflation forecast should bake in a large margin of error. Still, is there something useful we can say about future inflation? At a minimum, it would be nice to have some comfort whether we’re headed for deflation, low and stable inflation (say, 2%-ish), or high inflation (over 3%).
The traditionally most-accepted theory of inflation, as represented by Irving Fisher’s Quantity Theory of Money, held that an increase in the money supply always led to an increase in inflation. However, the last 10 years, and at least the last 20 in places like Japan, have exposed a big flaw in this premise: the US monetary base has increased 5.5x since January 2008, but the Consumer Price Index (CPI) is just 20% higher.
Our Multi-Asset team notes that the relationship between money supply and inflation has historically proved to be reliable, but only over long horizons (approaching 30 years). So perhaps there is still time for inflation to come through in response to the monetary expansion following the Global Financial Crisis. In the meantime, the money-supply effect appears to have been swamped by other factors, such as deleveraging by both public and private sectors, and globalisation. More precisely, our Multi-Asset colleagues attribute the disinflationary pressures of the last decade to what they call the “five Ds”:
If these factors, and others, can sap the inflationary properties of a ballooning money supply, then tracking their changes should be worthwhile. American economist Frederic Mishkin, for example, believed that an increase in money supply was not, by itself, enough to trigger higher prices. Rather, it needed policymaker support (i.e., fiscal expansion) without taxation, along with a specific low-unemployment objective. We are now getting this: while fiscal austerity was very much the mantra after the financial crisis of 2008/2009, the pandemic has forced governments to spend. This is a big change compared to the last 10 years.
At the same time, central banks (particularly the US Federal Reserve (Fed)) have begun to state publicly that they might be willing to tolerate “moderately” higher inflation than their 2% targets, to ensure that inflation expectations are properly anchored around that target and not lower. This is an attempt to use one of the circularities of inflation theory, which holds that a simple increase in inflation expectations might be enough to create higher actual inflation. The point is that, by telling the market that it will tolerate moderately higher inflation, the Fed is attempting to rectify the fact that inflation expectations have generally been too low over the past five years. It’s another significant change.
At the same time, we are witnessing at least some rolling back of globalisation. This ‘onshoring’ trend repatriates activities that had been moved to lower-cost locations. It’s hard to see this happening on a massive scale, but at the margin it raises producer costs and marks a shift in yet another heretofore deflationary factor.
Finally, we haven’t had a credit crunch this time. House prices are not falling (quite the opposite), a good number of households have saved substantial amounts during this pandemic, and the banking system is in good health. At the margin, all these factors were deflationary over the last decade and will not be deflationary this time around. Yet another change.
Of course, the above discussion guarantees nothing. There are still plenty of potentially deflationary forces that we have not discussed, namely that corporate leverage is high (particularly in the US), that asset prices are also high and therefore a crash would create a significant adverse wealth effect, and that demographics are still not supportive of rising prices. But on balance, our colleagues make the point that an inflationary scenario, especially in the US, is quite easy to construct. At the very least, perhaps it makes a deflationary outcome unlikely. The colour-coded table below, compiled by the Ninety One Investment Institute, summarises inflationary forces in each region, and suggests that the US is the best candidate for sustained reflation (green is positive for inflation, red is negative and orange is in between).
Source: Ninety One Investment Institute, 2021
It is worth pointing out that the market is already pricing in something like the above. To gauge inflation expectations, central banks look at the level of inflation predicted by inflation-linked government bond markets. For 2026-2031, the expectation is for average inflation of 2.1% in the US and 1.3% in Germany. Inflation expectations in the US therefore appear, in central bank lingo, ‘well-anchored’; i.e., the market expects some inflation, but not a lot of it. In Europe, by contrast, expectations are well below the ECB’s official 2% target.
The interest-rate swap market points to similar conclusions. The nominal interest rate that the US swap market is pricing in for the same period (2026-2031) is just 1.71%, resulting in a negative predicted real rate of about 0.4% (1.71% nominal rate minus 2.1% expected inflation). This indicates that the market is confident in central banks’ ability to maintain control of inflation, otherwise real rates should be well into positive territory (think of the aggressive rate hikes that Fed Chair Paul Volcker had to implement in the 1980s). For Europe, the expected nominal interest rate is 0%, implying a negative real rate close to 1.3% - a clear sign of scepticism over the ECB’s capacity to generate inflation. [Note on the UK: Unfortunately, assessing inflation expectations for the UK is not as straightforward due to the peculiarities of the index-linked Gilt market, in which relentless pension-fund demand has pushed prices up to a level where implied inflation expectations are no longer reliable - i.e., they look too high.]
The government-bond yield curve sends a similar message. It suggests that, for the next two years or so, interest rates in the US, Europe, the UK and Japan will be pretty much pegged at zero or below. Beyond that, the market is beginning to price in some interest-rate increases, in some markets more than others. This is what the chart below shows, with the 2yr/10yr US yield spread indicating a much greater propensity by the Fed to eventually raise US rates than the ECB in Europe, with the UK somewhere between the two.
Even so, the rate rises the market expects are not large. Once we remove the first two years of zero rates (the US 2yr note is yielding just 13 basis points at the moment), the period between years 2 and 10 only prices in US interest rates of 1.34% on average (Germany and the UK are much lower). Once again, it appears that if inflation is coming, the market is not worried about it.
Based on these assessments of inflation, we can perhaps draw some practical conclusions for investors, and consider the implications for portfolio positioning.
Inflation protection opportunities:
Value portfolios and inflation risk:
US 60 day rolling correlations vs. US treasury yields
Source: Alliance Bernstein, January 2021
Global equities 180 day rolling correlation
Source: Alliance Bernstein, January 2021
In summary, then, we would highlight that value stocks are cheap, uncorrelated with other equity factors and positively correlated to bond yields. If the world is heading for even a moderate sustained reflation, then value stocks should do well and provide some much-needed diversification. If inflation actually surprises to the upside, then we think a value portfolio is likely to be one of the only viable places to hide.
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