This article first appeared in the Telegraph
CENTRAL bankers know what to do about inflation. They have a plan for the opposite problem, falling growth and recession. What they struggle with is the unholy combination of both challenges at the same time - stagflation.
For investors, too, the unhelpful mix of economic stagnation and rising prices makes life difficult. You can find assets that are more resilient in the face of inflation. Some investments are more defensive at times of slowing growth. But building a portfolio to handle both simultaneously is tricky.
Fortunately, this is an unusual combination. The last time we really experienced it was after the oil shock of 1973 when the Arab world’s punishment of Israel’s supporters in the Yom Kippur war caused the price of energy to soar and the economy to grind to a halt.
The jury is out on whether we are about to experience another bout of stagflation, but the odds are shortening. The balance is different on either side of the Atlantic - with inflation the bigger concern in the States and growth the main worry here - but on both sides of the pond it adds up to the same ugly cocktail.
In both the US and Europe, the issue predated the war in Ukraine, but the conflict has clearly made things worse on both the growth and inflation fronts. Just as it did in the 1970s, an energy crisis has raised costs, reduced demand, squeezed profits and increased unemployment. This time around, however, the oil and gas supply shock has been layered on top of an existing supply chain crisis, caused by the pandemic.
Even before Russia invaded Ukraine, there was a chance that a central bank policy error could turn the fight against inflation into a trigger for recession. Today, however, there’s less room for manoeuvre. The level of uncertainty around the various shocks, and the higher level of inflation and lower level of growth as a result of the war, mean it is increasingly likely that the Fed or its counterparts over here will get it wrong.
The balance of probability is that central banks will err on the side of caution, sticking to their planned tightening path but at a slightly slower rate and possibly with a lower end point. Inflation will be seen as the lesser evil than recession.
Even if that is not how the challenge is framed, the reality is that the scale of tightening required to return inflation to target would bring the economy to its knees. It’s just not going to happen that way. More likely, we are going to have to position ourselves for a world of sluggish growth and higher inflation. So how to do that? Here are some possible solutions:
First, avoid nominal bonds. The index-linked variety may do OK, but inflation is a killer for fixed income investments. Rising bond yields equate to falling bond prices and rising prices reduce the purchasing power of both the fixed interest payments and fixed return of capital they offer investors.
When it comes to picking the shares for the equity portion of a portfolio, here are some useful questions to ask:
Does this company benefit from a store of value? A housebuilder, for example, that acquired its land bank several years ago and now sits on an accumulating asset, might be well placed in this environment.
What does the cash flow look like? A good example might be a supermarket which takes cash from its customers at the point of purchase but pays its suppliers some time later, perhaps as much as two or three months later. Supermarkets also benefit from the power imbalance between a large purchaser and a usually smaller supplier.
How important are input costs? A media company, for example, or a technology stock will obviously be less impacted by rising energy costs than an aluminium smelter to make an extreme comparison.
How high is return on capital? Businesses making expensive kit with lots of intellectual property will be better protected in an environment of rising prices than a high volume, low margin operation with little pricing power. If you can live with the ethical considerations, the defence sector fits the bill and is looking at an extended period of full order books if Germany’s recent pivot is any guide.
How’s the balance sheet? Companies with relatively high borrowings, fixed at today’s low interest rates, may look interesting. The assets they acquire with that debt will grow in value as prices rise but the real liability will be inflated away. It’s the same thinking that encouraged my parents’ generation to take out the biggest mortgage they could afford in the 1970s.
Is this company caught in the squeezed middle? The super-rich don’t know or care if the economy is in boom or bust. They carry on regardless. And at the bottom end there’s always the scope to benefit from downshifters. It’s the businesses operating in the middle-ground that get caught in the vice.
Who’s selling what’s going up? Many oil and gas companies will break even at $70 crude. Even after the recent retreat, oil is priced at around $100 a barrel. At that level, energy producers are awash with cash, and they tend to hand a high proportion back to investors in the form of dividends and share buybacks.
And finally, don’t think that gold’s recent rally towards its all-time high of $2,070 an ounce is the end of it. Goldman Sachs thinks the precious metal is headed towards $2,500. If we really are revisiting the 1970s, that might be conservative.
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