Inflation is the hottest topic in the markets right now.
There are a lot of “ifs”, “buts” and “maybe” involved. Are the current inflationary pressures really sustainable? What happens as we learn to live with Covid rather than locking ourselves in every five minutes? Can higher interest rates help untangle supply chains or reduce energy costs? (No).
These are all important questions, but this whole debate misses a key point about why inflation might be more persistent than expected.
Which is this: it’s the most practical result politically.
Inflation is a key part of the solution
In a recent article, “Inflation is here! And now ? Chris Brightman of Research Affiliates points out that all over the world “deficits are exploding, public debt is soaring and inflation is soaring”.
If you look at the G7 countries (US, UK, Germany, France, Canada, Japan and Italy) then, on average, “total debt levels as a percentage of GDP have doubled from 80% in 1995 to more than 160% in 2020”. The largest increase in debt occurred last year, with debt levels rising to rates that even exceeded the “growth of the global financial crisis of 2008-2009”.
Deficits (the annual gap between spending and tax revenue) have also exploded. Over the quarter century to 2020, the average G7 deficit was 3% of GDP. It should be noted that in historical terms, a 3% deficit has always been considered a game with fire. Yet in 2021, the average has reached a 10% deficit.
Now most of these actions were justifiable, certainly in the early days of the crisis. If the state chooses to close businesses, it must compensate those businesses and their employees for the loss of revenue – this is only fair.
But that means government balance sheets look in tatters. It’s lasting when they all look like that, but, when the pandemic era ends, the process of repairing the balance sheet must begin. The tricky thing is how to do this.
More than any other factor, this huge public debt problem explains why inflation – rather than being a problem – is actually part of the solution (at least from the government’s perspective). Central banks might be able to pull back quantitative easing (QE), but interest rates can’t go much higher – ‘G7 finances can’t afford nominal interest rates above rates current inflation rates.
Raising taxes is another option, but that won’t be popular at a time when prices are also rising. Because of this unpleasant dilemma, politicians may well decide that “sustained inflation may be the most expedient policy path to diminish the real value of excessive public debt.”
(In very simple terms, if inflation is rising faster than interest rates, the cost of your debt decreases each year because your interest costs are not rising as quickly as inflation.)
Buy value, sell growth
Brightman also points out that even if the withdrawal of QE doesn’t do much to ease inflationary pressures (if it has mostly inflated asset prices rather than affecting the “real” economy, then there is no no reason to expect it to hugely affect the “real” economy on output either).
However, this means that the possibility of a liquidity “incident” is higher. In other words, markets dependent on a lot of excess liquidity could experience difficulties when said liquidity is withdrawn.
So what does all this mean for an investor? On the liquidity side, this alludes to what we have already seen. The most cash-dependent and “volatile” assets — “growth” stocks that currently have no profits and little more than a good story — have already fallen sharply, and that worry is showing signs of easing. spread to the most reliable growth stocks (see Nasdaq’s tricky start to the year).
But what about “what to buy”? The good news is that while the US in general and the tech sector (growth stocks, essentially) in particular are very expensive by historical standards, not everything falls into this basket.
Indeed, on the market value side, many other assets are simply not expensive at all. Research Affiliates estimates that value stocks in the United States are valued for real long-term (i.e. after inflation) returns of over 6%, and up to 10% “for Japanese markets, European and emerging countries”.
In short, if you are looking to position your portfolio for an environment that will see a period of sustained inflation, then you should reduce your exposure to US growth stocks in particular, and increase it in areas outside of the US.
If you’re looking for exposure to UK value stocks in particular, you should listen to the latest MoneyWeek podcast, where the managers of Temple Bar Investment Trust (a value specialist) discuss their favorite stocks with Merryn.