The era of low interest rates and low inflation seems to be behind us, with most investors and governments admitting that inflation is more persistent rather than being of a transitory nature, as was previously put forward. Rising fuel and energy prices, primarily as a result of the war in Ukraine, supply chain disruptions due to China’s Covid policies, and pent-up demand have all stoked levels of inflation many countries have not seen in decades.
The US, Eurozone, and UK are all experiencing inflation rates above 8%, while countries like Turkey, Poland and Hungary are seeing double-digit increases in consumer prices. South Africa looks a little better at 6.5%, but rising fuel, food, and electricity prices, together with a sharply weaker rand/dollar exchange rate, are likely portenders of higher inflation levels yet to come.
We’ve addressed concerns about inflation in our newsletters and articles throughout the year, but we thought it would be worth taking a deeper look at how we are positioning clients for this adjusted economic climate. In short, we believe that our quality philosophy is more relevant than ever in a time of high inflation, and our reasons supporting this thesis are outlined below.
Comparing asset classes
When we look at the analysis in the following table, which depicts how different asset classes have performed in times of high inflation, it becomes clear that there is no silver bullet for protecting investors’ portfolios. In other words, asset classes that may perform relatively well during inflationary environments, do not necessarily provide outsized returns over full economic cycles.
Taking a conservative approach – switching to cash and staying out of the market – makes your portfolio vulnerable to the ravages of rampant inflation. Interest rates are still well below the prevailing inflation rate and thus real returns from cash are negative, especially on an after-tax basis.
Figure 1: JP Morgan analysed how different asset classes and active strategies performed over inflationary periods in the past century.
Fixed-rate bonds also provide no protection against rising inflation and face the risk of capital loss as interest rates rise.
Gold, the traditional inflation hedge of choice, has historically fared well in high inflation regimes, but delivers paltry returns outside such times. However, more recently, gold is actually slightly lower than at the start of 2021, despite its positive track record in times of high inflation. Its long-term performance has still lagged the MSCI World Index, notwithstanding the latter falling by more than 20% in 2022.
Other commodities – specifically oil, natural gas and some soft commodities – are performing better. Interestingly, they themselves are a major cause of inflation, partly due to the war in Ukraine having severely disrupted supply. Yet commodities tend to underperform when measured across a longer timeframe. Three-year returns from the S&P Goldman Sachs Commodity Index have only recently surpassed the S&P 500 as commodities catch up after underperforming significantly up to and including the Covid sell-off of Q1 2020. Commodities are cyclical in nature and don’t provide compelling long-term returns. To get stellar returns, you would need to trade the cycles, which is not a successful strategy in our view.
Equities in times of high inflation
At Dynasty, we aim to position our portfolios for long-term, defendable growth rather than to respond to market volatility or to make macroeconomic forecasts. Our view is that there are only two major asset classes, namely equities and property, that deliver real returns over longer investment horizons, albeit with the risk of sharp drawdowns in the short-term.
With reference to property, on the one hand, rising interest rates in response to rising inflation can cause property valuations to fall; on the other, upward rental revisions and higher replacement costs may provide an underpin to property prices in inflationary environments. The hybrid working and online shopping trends may also prove to be serious headwinds for commercial property in the years to come.
When it comes to equities, rising interest rates and inflation tend to be bad for consumer and business spending, and hence negative for stock valuations. However, counter-cyclical stocks with high margins, low debt, low capital intensity and significant pricing power tend to perform better than other stocks with less favourable metrics under high inflation regimes. For these reasons, investing our clients in quality companies that have robust business models, sustainable earnings growth, pricing power and low leverage, provides – in our view – a defendable approach for a high inflation environment.
Figure 2: JP Morgan comparison of how different equity sectors performed in high inflation regimes.
During boom cycles, many of these quality companies trade at prices lower relative to their earnings or cash flows than market darlings such as big tech, and thus tend to underperform their high-beta peers in these times. However, the consistency of their underlying business models means we do not need to second-guess the geopolitical and economic cycles that shift market sentiment. Backing quality therefore offers a partial shield against inflation, while simultaneously positioning a portfolio for long-term growth, even though the share prices may not reflect the fundamentals of the underlying businesses in the short-term.
