In the UK, the situation is being exacerbated by the withdrawal of European workers as a result of both the pandemic and Brexit.
Is inflation transitory or becoming entrenched?
The truth is that it remains too early to judge. The distortions brought by the pandemic are still working their way through year on year statistics and will continue to do so for some months to come. In the UK for example, the jump in August 2021’s inflation rate was partly due to August 2020s, 50% discount on restaurant food and the governments eat out to help out scheme, which has now dropped out of the calculation.
The deflationary forces of technology, ageing populations who spend less and indebtedness remain and we will also expect the supply bottlenecks, which have been a feature and problem of the economic bounce back to ease. However, the vast sums now being spent on infrastructure, including de-carbonization as well as social programs, such as president Biden’s $2 trillion American families plan and the UK government’s levelling up schemes are contributing to upward pressure on both wages and raw materials.
In the UK, the situation is being exacerbated by the withdrawal of European workers as a result of both the pandemic and Brexit. Incidentally, the well-publicized challenges being presented by skyrocketing gas prices and the shortage of lorry drivers are not peculiar to the UK but are global and the consequences of perfect storms of supply, demand, COVID climate and policy.
Taking all these factors into account. Our best guess is inflation will fall from today’s elevated levels, but in the US and particularly in the UK could easily settle higher than the 2% level the central bankers are targeting. As much as the data measuring growth and unemployment corroborate, the continuing recovery from the pandemic is the inflation numbers that we’ll continue to monitor most closely and which are likely to have the greatest influence on the actions of central banks and hence the future course of financial markets.
What is your view on bond markets?
Government bonds may widely be regarded as dull investments, but they provided a rollercoaster ride for investors in the third quarter of the year. The price of a conventional bond is very sensitive to the rate of inflation because the regular interest payments and repayment of capital maturity are fixed sums. If inflation is rising, the price of a bond tends to fall because the value of those payments in real terms is being eroded.
Whilst the meshing has not changed however, central bankers have clearly become more jittery about inflation over the last few months. And the timings of expected increases in interest rates and the scaling back of bond purchases under the quantitative easing programs have been brought forward. We expect further bouts of volatility as we saw in the third quarter, but it seems probable that government bond yields will grind higher over the medium term as monetary stimulus is slowly withdrawn and investors demand rates of return that are higher than inflation. Interest payments may be sufficient to offset capital losses as yields rise, but return expectations for government bonds are modest.
We also continue to question if the optimally attractive yields of many lower-quality corporate bonds are sufficient compensation for the risk of default. Where, and as much as our own investment management mandates allow, we prefer to allocate to tactical bond funds. Due to our own very flexible mandates, such funds are nimble and can cherry-pick the very best opportunities as they arise across the wide spectrum of bond markets.
Do equities remain the only game in town?
with cash yielding nothing and bond yields still very low and probably heading higher, equities remain the only asset class in which investors can hope to maintain or grow their capital in real terms, all be it with greater risk to that capital. For at least the next quarter or two, stock markets should continue to be supported by strong economic growth and the impressive bounce back in corporate profits.
Past precedent also suggests that stock markets can take moderate inflation and gently rising bond yields in their stride. However, there are challenges on the horizon. First higher wages and rising costs for raw materials are putting pressure on corporate profit margins.
Second corporate tax rates are going up.
Third as the worst ravages of the pandemic pass further into the past, year on year growth in corporate profits will be harder to achieve and will slow markedly. Most important of all though is the risk that inflation remains stubbornly high, forcing central banks to raise interest rates faster and by more than investors currently, expect.
Notwithstanding that such action could ultimately lead to a recession. This would undermine valuations, which are lofty and which there is little or no margin for safety. For these reasons, we would probably only consider increasing the exposure to equities within portfolios if there were to be a substantial sell-off in stock markets.
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The information within this article is for information purposes only and does not constitute investment advice. They represent the opinions of the fund manager and those of Square Mile. It does not contain all of the information which as an investor may require in order to make an investment decision. Any reference to shares/investments is not a recommendation to buy or sell. If you are unsure, you should seek professional independent financial advice.
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