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Inflation gets real – time to adjust

 
The Green Line
Hermione_Davies
Hermione Davies
Investment Director

Suddenly people are talking about inflation again. 

Not many of us are regular buyers of patio heaters and trampolines, so may not have realised that the prices of these lockdown enhancers are in many cases up over 50% in a year.1 But a recent study of the prices of 750 ‘essential’ items sold on Amazon, showed that by December last year the prices of 409 were up by over 20% from pre-pandemic levels, while 136 had more than doubled.2

More significantly, many companies have been reporting cost pressures as the picks and shovels of global supply chains, transport and energy costs, have rebounded sharply. The chart shows that container shipping rates have recovered much faster than in the last two recessions. And, as production interruptions in the west have increased reliance on the east, the cost of shipping containers from Asia to northern Europe has increased even more sharply, from about $2,000 in November to more than $9,000 in January, according to importers.3 Meanwhile oil and gas prices have more than doubled from their lows,4 copper is up 70% to an eight year high5 and corn prices are rocketing.6

Our view is that rising prices in some of these traditional industries are signalling that the recovery, when it comes, will look very different and be much more inflationary than anything we have seen for 30 years.

This matters. Central bankers may believe they have the measure of inflation and so can afford to run the economy ‘hot’ to support the post-covid economy. But our view is the benign conditions we have enjoyed over the last 30 years of rapid global growth, low inflation and high returns on capital are not thanks to central bankers. They are largely the result of some very helpful social, political and technological developments which are now going into reverse. Most importantly, China cannot join the world economy twice.

And after a ‘nobody’s fault’ crisis, governments are likely to keep on spending. So, just as the pandemic-driven recession has been historically unprecedented, the rebound in both growth and inflation could be much more powerful than many expect. And in that case, we run the risk of policies which will turn out to be dangerously inappropriate to the new regime we are entering.

This has direct consequences for investors because for thirty years they have benefitted from the combination of falling interest rates and a negative stock-bond correlation, which meant that a portfolio combining bonds and equities gave you both good returns and protection from the full impact of equity market falls. But this ideal combination rested upon low and falling inflation. Financial markets may initially enjoy the warm glow of rapid real growth. But signs of a return of inflation could be profoundly damaging to bonds and growth equities.

So how to position portfolios? Our equities are concentrated in financials and also real economy companies, which are well positioned for this environment. They have taken advantage of the pandemic to cut operating costs, often helped by new technology, and yet reduced competition will give them pricing power when economies reopen. And, since wartime levels of government debt mean that central banks will resist raising interest rates, we hold inflation-linked bonds and gold. Finally, since this shift to a more volatile and inflationary macro environment could be a profound shock to the certainties of the last thirty years, we hold powerful unconventional protections.

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A view from the bridge
January 2021: 2020 will loom large on financial markets for many years to come. As we cautiously make our way out of the crisis, Duncan MacInnes and Fiona Ker review the more startling developments of the last year, share their insights into the ongoing recovery and look ahead to some of key challenges facing investors in 2021.
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  1. US PIRG Education Fund report, Jan 2021
  2. Ibid
  3. Freightos Baltic Index, via ft.com 19 Jan 2021
  4. FactSet, 10 Feb 2021
  5. London Metal Exchange, 10 Feb 2021
  6. US front month corn futures, via Macro Strategy Partnership, 29 Jan 2021

Chart source: HARPEX, peak of US output = 100

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London
80 Victoria Street
London SW1E 5JL
Edinburgh
31 Charlotte Square
Edinburgh EH2 4ET
Paris
103 boulevard Haussmann
75008 Paris, France