Over the past number of years we have often discussed the topic of inflation and its importance as an underpin for asset prices. With low inflation – a function of technological innovation and globalisation as key drivers – allied with low interest rates, times have been good for investment markets. Are we finally at a tipping point, where the multi-decade trend in lower rates and inflation is set for a change in direction? It looks increasingly likely.
In the below commentary we take a look at why inflation is such an important input when making investment decisions and provide an updated view on global and local markets.
The chart below highlights the current level of US inflation, a key indicator dictating decisions around interest rates, which in turn impacts the global cost of capital, money flows between markets and the value of financial assets.
For much of 2021, the term ‘transitory’ was used to play down the inflationary effects of massive stimulus packages rolled out across emerging and developed markets to mitigate the financial effects of COVID. For many this was never a transitory move upwards in inflation, given the magnitude of what was being injected into global markets. Some months later, the term ‘transitory’ is slowly being retired, being replaced with ‘persistence’. While this may seem like our investment futures hinge on subtleties of the english language, in fact it points to a managed guidance towards a reality where the brakes need to be put on policies supportive for financial markets.
Recent Drivers of Inflation
While supply chain bottlenecks are an inflationary consequence of COVID, the extent of these issues and the knock-on effects look to have been underestimated. In the below chart we can see how the disruptions in supply chains have steadily increased since 2020, most notable are the US and Eurozone.
There are other drivers of inflation too:
- a trend towards ‘de-globalisation’, where countries exposed during the COVID crisis have resolved to insource or change a number of their key productive inputs. A key example here is semi-conductor chips which are widely used across various industries including vehicles and consumer electronics.
- the shift towards carbon neutrality and ESG is widely believed to create short and medium term inflation pressures as the supply and demand of various items adjusts;
- wage inflation – fueled by social grants (less inclined to work) and higher demand, wages have been a key driver of inflation particularly in the US where this is one of the largest inputs to CPI
With the Fed’s guidance on transitory inflation seemingly incorrect, again this points out how difficult it is to forecast inflation. The irony is that this error in itself could become inflationary, given the nature of how it can snowball. The simple fact that companies may expect inflation, causes them to raise prices, thereby creating the self-fulfilling outcome they are expecting to occur.
At the moment it does feel as though we are reaching or have reached peak levels of financial market excess. Super high valuations on more speculative assets (SPAC’s, tech shares etc), the return of the retail investor, the clamouring for various goods and services across regions and industries.
Overall, it would be wise to adjust future expectations accordingly. Fortunately, the past decade has allowed most global investors to bank abnormally high returns after inflation, so at least the base is high.
Over the past year there have been some significant winners and losers, providing an investment opportunity set where being selective can add significant value in future.
Emerging Markets took a significant hit as Chinese regulations on certain industries caused many investors to sell given the growing uncertainty. The Chinese migration towards a policy of “common prosperity” relative to “growth at all costs” has wide implications which directly dampen the prospects for a number of high-flying companies. Often these big news items are best ignored, but when a policy change has real world ramifications (such as online education should be non-profit) then its best taken at face value.
Chinese property was also substantially weaker as the excesses of the past caught up with them, initiated by the governments so called ‘three red line’ rules.
In the move from ‘transitory’ to ‘persistent’ inflation towards the end of 2021, there have been further losers. Quality and Growth shares demonstrated their vulnerability to higher costs of capital by falling 8% and 10% respectively compared with Value shares which tend to be beneficiaries of higher inflation. The wide discrepancy between these classes of equity persist however, and given the relatively small rise in US bond yields (a key cost of capital input), we may have only seen the start of this rotation. This is nothing new – we saw early signs of value share outperformance as the vaccine was developed in Q4 2020. After a stop/start 2021, value shares are still offering attractive upside with forward earnings multiples in the low double digits. The chart below highlights the dangers of not being selective in what you buy. In this case US equity prices have run far ahead of their earnings trend, which despite having a strong recovery, are being outsprinted by higher than usual risk appetites and willingness to pay up for safety or innovation.
Yet with all the talk of inflation around us, the powers that be (i.e the Fed) still retain a desire to support financial markets and growth more broadly. Don’t be surprised if we end up with a further round of fiscal stimulus in 2022, and interest rates lower than what they are today.
Global Cash and Bonds: a very expensive parking spot
When interest rates have only one way to go but up, and bond prices only one way to go but down, and then you get 7% inflation, it’s a sure-fire way to learn a lesson around capital preservation. Cash and bonds remain unattractive investments for the meantime. With the possibility of interest rate increases being brought forward, we may have the opportunity to buy into bond weakness or higher yielding cash investments, but over the next 12 months this would take a significant knee-jerk reaction or a taper tantrum such as that seen in 2013/2014. For now, bonds are best avoided, and cash can be held only to dilute the volatility of other assets and to act as a parking spot for equity purchases should these fall in value.
Overall then, the outlook is mixed but the main themes and drivers remain in place. The way to read this is then:
- Global value still looks attractive, given earnings levels and relatively depressed prices on certain types of shares.
- Global quality is nominally expensive, but there are mitigating factors and this can still be held in minority positions in portfolios.
- Global growth, despite a material lag since Feb 2021, remains elevated. The investment case here rarely rests on simple PE ratios, but 2022 may see us having a good opportunity to upweight growth equity exposure which to date has been run conservatively low. To be able to access the upside opportunity of shares like Tesla, you need to be invested. This also means that should the growth sell-off continue, it could be a little painful in the short run.
- Emerging Markets are looking interesting and are likely a place to look for opportunity. Low valuations and the China sell-off has been significant, but facing a potential lower growth global environment and rising hard currency interest rates.
- Global cash and bonds held at the lowest level possible still makes sense.
- Keen to time the market and sell out? No – the potential for the status quo to remain (earnings expansion, persistent high prices, etc) is still significant and the earnings cycle in various regions is still supportive. Despite the risks highlighted above
this is not a market to try and outfox.
- Gold may turn out to be a haven, just as appetite for crypto is put to the test.
South Africa: back from the brink?
Local equities have literally doubled off their COVID lows, which if anything should caution us to write off the underdog in future. So, what now? The commodity cycle is high and while there may be some sustained global support the chances are lower that this can continue to bail out much of our equity market (and fiscus).
Local smaller companies, which have been depressed for a number of years, staged a huge comeback in 2021 as the best performing asset class, but with a weak domestic economy the prospects are relatively lower. There does appear to be a decent investment case for the market as a whole though and many funds remain fully invested, highlighting sectors such as the banks, some commodity companies and then specific counters, the biggest among them being Naspers/Tencent. Having fallen 20% in 2021, an underperformance of 50% relative to the All Share, this may be the counterbalance we need to help steady returns in 2022. With the price discount in Naspers of 50-60% relative to the underlying asset value (predominantly Tencent), this is seen by some funds as a ‘deep value’ opportunity. The value unlock remains elusive however.
Broadly though there does appear to be a decent investment case for local equities looking ahead. This is supported by the fact that prices remain depressed relative to what has been a surprisingly strong recovery:
Local interest rates have already started moving up, but cash (money market) remains a negative real return asset for now. We may see this become a viable option later in the year if local inflation remains muted.
SA government bonds remain a favoured investment destination. For both local and global investors, the high real yields remain sufficiently attractive despite the risks. They will face headwinds however should US rates continue to trend upwards. It is also worthwhile keeping an eye on Reserve Bank decisions and guidance regarding interest rate hikes and how they target what seems likely to be a lower inflation level. Key risks to watch in 2022 relate to government policy direction as well as the potential for electioneering to start distracting the leadership from enacting the changes which are desperately needed.
Local property has made a substantial recovery and delivered strong returns in 2021. However, much of this is due to price rerating rather than meaningful earnings/distribution growth. The assets have been cleaned up so to speak (asset sales, debt reduction, etc) so on the whole look better qualitatively, but they are still facing numerous headwinds from a domestic demand perspective. Filling the empty seats will remain a difficult task, and many leases will be up for renewal to the new (lower) post-COVID levels. We remain cautious on local property, but it is an improving asset class.
With US inflation higher than local inflation, the implied value of the rand is stronger. At current levels, it is close enough for us to treat as ‘fair value’, and so we would not be advising on any investment changes as a result of currency alone.
With almost two years of post-COVID support behind us, chances are that 2022 is a little bumpier. The threat of inflation, policy errors and the like can quite easily derail elevated risk appetites. Each fund allocation needs to be carefully considered to ensure that there is a sound investment case and to mitigate the potential for anchoring on the latest news (Such as 7% US inflation). Portfolios are not designed for one outcome, and so we place great value on diversified perspectives and positions which means it is unlikely that all will be firing at the same time. Saying that, our preference remains a significant value exposure both locally and offshore as the best risk adjusted opportunity to grow wealth.
Relative value of asset classes vs long term history