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24 June 2021

Recovery and Inflation

While some sectors of the economy have fared better than others during the pandemic, with many examples of companies at both extremes, there has been an overall monumental decline in economic activity. This deep and aggressive deterioration in economic and business stability naturally affected the cyclical value stocks significantly more than their growth counterparts, owing to their business models and the products sold being particularly sensitive to changes in economic circumstances.

This has continued to perpetuate the outperformance of growth versus value stocks that has occurred over the past ten years or so, significantly widening the gap as the more forward-looking and asset-light companies are able to better adapt, thanks to their more agile business models and targeted products.

However, the outperformance of growth stocks since the financial crisis has been accelerated somewhat by economic conditions that favour faster growing companies. This near-perfect storm has consisted of long-term inflation readings below expectations coupled with rock bottom interest rates across key global regions. While rates did rise in the four years leading up to 2020, the COVID-19 crisis soon sparked central banks to stoke their respective economies by sending them back down, and in the case of the US, to 0.25%, a rate that was seen from 2009 to 2016.

With rates close to zero, companies were able to borrow at extremely low interest rates, giving them the ability to spend more aggressively, aiding expansion opportunities and allowing them to invest heavily into research and development opportunities, helping to drive revenue growth. Growth companies were able to use such tactics to accelerate their growth further and sustain high rates of expansion for a number of years. Companies such as Amazon and Alphabet (the parent company of Google) are perfect examples of this. Both firms are valued at over US$1tn, however, despite their size they have been able to sustain impressive revenue growth rates of 29% and 20% respectively when averaged out over the past five years. While undoubtedly the main reason behind this is the now essential products they offer, vital in our daily lives, the capability to remain agile and consistently target customer needs will derive, in part, from the ability to raise funds quickly and cheaply.
US-Annual-Inflation-Chart-(3).png
US annual inflation rate 2011-2021 - Source: US Inflation Calculator, U.S. Labor Department’s Bureau of Labor Statistics

However, it is not just the direct impact of low interest rates that helped growth companies outperform. The lower rate of charges on financial products such as credit cards and mortgages have left many with higher levels of disposable income with which to purchase discretionary products such as luxury goods, automobiles and clothing, amongst others.

Nevertheless, in recent months there have been multiple signs of change, not only across financial markets but also within the global economy. Inflation has begun to rise rapidly, especially in the US, given the reopening efforts, rising to 4.2% so far this year, a level not seen since before the financial crisis.

This anticipation of higher inflation and, by association, interest rates, coupled with a reversal and explosion in consumer spending, has helped cyclical value stocks outperform over the past few months. Stocks from banks to oil have performed strongly, with indices that possess a high concentration of such stocks also posting solid gains while tech-heavy indices such as the NASDAQ Composite struggling as its constituents grapple with the short-term reality of underperformance.

The million dollar question, then, is whether higher inflation is transitory or permanent, that is to say whether it will last only for the duration of the COVID-19 recovery or whether investors and savers will start having to get used to the idea of higher inflation persisting as it did in the 1970s and 80s. While investors do have a long history of overestimating inflation, the recent spike does provide cause for concern for many who have enjoyed strong market returns in recent years owing to the tech-based rally that has continued for some time now.

The problems associated with higher inflation and interest rates also present opportunities, in particular within the non-equity space. While the umbrella term of ‘alternatives’ does encompass many asset classes, sectors such as infrastructure and property possess some of the strongest inflation protection characteristics. Such sectors typically lease out or sell a physical asset which, if on a multi-year deal, has yearly inflation-linked price increases baked into the contract, allowing the owner to avoid erosion of capital. Investments into commercial property and infrastructure projects of which the government is the main/sole customer have typically benefitted from longer contracts with inflation linked price rises.

While there are many ways in which to protect against inflation, a select few non-equity assets are just one way to do so. However, it is important to consider such options given the negative impact inflation and rising interest rates have on bonds, which have historically formed roughly 40% of balanced portfolios. Future performance and market dynamics will likely depend heavily on the future movements of inflation and interest rates and investors should be prepared to reshuffle their portfolios accordingly. If investors are of the belief that inflationary pressures will continue, a higher weighting towards inflation protected assets and more cyclical sectors such as banks and energy may be a wise option. However, despite all the recent talk of higher inflation, investors and economists have historically overestimated inflation. While the recent spike is somewhat worrying, it is not out of the ordinary for a rapid economic recovery, such as the post-COVID-19 bounce we are starting to experience. As such, the recent dip in growth stocks may represent a potential buying opportunity to purchase fast-growing assets with strong future potential, at a reasonable discount.

This article was taken from the June 2021 issue of the publication, Market Insight. To sign up for our investment publications please visit www.redmayne.co.uk/publications.

Please note that investments and income arising from them can fall as well as rise in value. This communication is for information only and does not constitute a recommendation to buy or sell the shares of the investments mentioned.
Recovery and Inflation

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