Central banks globally have stepped in to provide governments with the financing that they have required, resulting in vast waves of liquidity entering the system.
In the latest Market Update from Square Mile, Investment Director Jason Broomer reviews the circumstances which have led to the potential return of an inflationary environment.
The pernicious impact of inflation on savings during the 1970s will be within the living memory of many people. Today we find ourselves in an environment where there are real concerns of a return to rampant inflation, given the recent flood of money that has been pumped into the system. Governments around the world have spent huge sums combatting the effects of Covid-19. According to the ONS, the UK government alone had spent some £270 billion in this battle, up to December 2020, equating to around £4,000 per person. This money has, for the most part, been funded by borrowing and the Government’s deficit has ballooned to the equivalent of 20% of GDP, something which is almost without precedent outside wartime.
Central banks globally have stepped in to provide governments with the financing that they have required, resulting in vast waves of liquidity entering the system. These QE programmes have comfortably surpassed the sums that were injected into the system following the great financial crisis of 2008/2009. Another important difference is that today this money has gone directly into people’s pockets; 10 years ago, it was used to prop up the banking system with banks using this liquidity to restore their balance sheets. In the UK and in Europe, this cash injection has principally taken the form of furlough schemes. This has been an incredibly expensive exercise by which governments have paid large swathes of the workforce to be inactive while their employers have shuttered their operations. The US Government has taken a slightly different approach preferring to send cheques to the vast majority of adults. Last year, Donald Trump sent each qualifying individual $1,800; Joe Biden is now working on a further package which could distribute another payment of $1,400 to a large proportion of the adult population. This is essentially helicopter money designed to support the economy and combat the deflationary impact of Covid-19.
A consequence of all this fiscal action is an increase in monetary supply, the likes of which we have not seen for some 20 or 30 years. This, according to economic theory, could result in inflation. However, there is a competing economic theorem adopted by various deflationists who argue that all this debt generation in itself reinforces disinflationary trends within the economy. This is best illustrated by an example. If you are considering buying a car, you have two options. You can either put money aside for two or three years and buy the car when you have saved enough. Alternatively, you could borrow money and buy the car today. By borrowing money, you create demand today; if you delay the purchase for three years, so too is that demand delayed. In the real world, we have seen a continual build-up in debt over the last 20 or 30 years, bringing demand forward to the present day. Of course, when tomorrow comes, there will be a demand deficiency. As a result, central banks and policymakers are continually having to stimulate the economy to generate the necessary demand.
It is not yet clear which of these two theories will win out. We do expect inflation to revive as economies emerge from lockdown and it may well rise above the Bank of England’s two per cent target zone. Indeed, a steady, stable modest level of inflation would be beneficial for the overall economy as it will help to address some of the current debt imbalances. However, while we do not foresee a significant spike in inflation and any rise is likely to be temporary, there is always the potential threat that inflation will continue to accelerate to quite concerning levels. This could have more severe consequences that financial markets currently do not anticipate, leading to significant dislocations. It is therefore important to continue to monitor how events unfold over the coming quarters.
In addition, Investment Research Analyst, Paul Angell, discusses the Legg Mason Clearbridge Global Infrastructure Income fund, a proposition which could be compelling against this backdrop.
The Sydney-based team behind the Legg Mason Clearbridge Global Infrastructure Income fund seeks to provide a high and growing income stream as well as a total return that comfortably outpaces G7 inflation. In doing so, it aims to deliver three core outcomes to investors. First, the fund should be able to provide a high level of income given the objectives of the investment team and the nature of the asset class in which they invest. Second, as an equity strategy, it should also offer capital growth along with attractive diversification benefits compared to broader global equity indices. Third, the fund should cope well in an inflationary environment as many infrastructure firms have cash flows that are linked to inflation. Over the long-term, the team aims to provide a stable series of returns, and when combined with the natural defensiveness of this asset class, the fund should operate with lower levels of risk than the broader equity market. This approach should result in an attractive risk/return profile over time.
Despite the strengths of the asset class, a rising interest rate environment would create particular risks, with those companies with poor growth prospects and that operate with high levels of debt being the most vulnerable. Also, the impact of regulatory or political decision-making can be meaningful within the infrastructure sector.
Infrastructure investing can be interpreted in different ways. From the Clearbridge team’s perspective, an underlying investment must be a real asset available for public use in order to be termed as infrastructure. Within these parameters, the team’s focus is on companies with regulated assets such as water and wastewater, gas and electricity transmission as well as corporations with user-pay assets such as airports, toll roads, railways and ports. However, higher-quality regulated assets will always make up at least half of the portfolio and these tend to provide consistent and defensive returns through the investment cycle. Companies are selected for inclusion in the fund based on the strength of their market position, the quality of their future cash flows, their exposure to true infrastructure assets, their levels of liquidity and the attractiveness of forward dividend yield. The managers are also looking to purchase companies at a discount to their estimation of fair value.
The fund performed very well in 2020, being up nine per cent versus the wider infrastructure index, which was down six per cent. The fund’s higher weighting to regulated utilities held up well during the market sell-off in March 2020. The team was then able to add to their renewable energy positions at more attractive valuations. This increase in exposure to renewables was a key contributor to outperformance over the rest of the year given the tailwinds behind green assets more generally. From an outlook perspective, the team is maintaining a very healthy dividend guidance of around five per cent per annum.
We like that the strategy is run by a team with a strong heritage and expertise in investing in this specialist asset class and we believe the investment process is straightforward and well-defined and that the targeted investment outcomes are attractive.
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