Without doubt one of the hottest topics on the minds of investors for 2021 is the risk of rising inflation and what this means for interest rates and equities.
Typically, in the early stages of a cyclical recovery when inflation expectations start to rise, we see the market gravitate towards the perceived beneficiaries including commodity producers, banks and many cyclical industrials. It has been no different this time around, with strong outperformance of many of the cyclical and rate sensitive parts of the market since the positive vaccine data started to emerge in early November 2020. In addition, a range of factors including low/negative interest rates and government stimulus, have contributed to pockets of rampant speculative activity which has driven the share prices of many unprofitable growth and thematic stocks to arguably unsustainable levels.
While we haven’t been surprised to see this market rotation take place, we strongly believe that over the long-term share prices will be driven by underlying company fundamentals. As concerns over rising inflation and higher interest rates continue to build, we feel this could be a catalyst for market participants to return their focus to some of the key fundamentals which have arguably been ignored during the early stages of the cyclical recovery.
Looking forward, we believe our ‘quality at a reasonable price’ investment strategy is positioned well to outperform in an inflationary and rising rate environment due to exposure to companies with good pricing power, strong balance sheets and highly visible cash flows, and less exposure to companies with high valuation risk. We also believe maintaining a portfolio with these key attributes has been a key reason why we have been able to outperform during historical periods of rising inflation and interest rates.
Below we take a closer look at some of the factors driving inflation and what this potentially means for portfolio positioning and global equity performance moving forward.
Outlook for inflation
While predicting the outlook for inflation is a difficult task given there are many variables that can influence the outcome, we believe it is a key risk factor that investors should be monitoring closely as it can have a material influence on stock price and portfolio performance.
Key factors contributing to increasing risk of inflation:
- Fiscal stimulus – the magnitude and speed of fiscal spending is a major factor that could drive a spike in inflation. In the US alone, the $5.2 trillion in COVID fiscal relief packages announced so far represent close to 25% of pre-COVID GDP, dwarfing the $831 million relief package during the GFC in 2009, which represented just 5.8% of 2009 GDP.
Source: BEA, CBO, U.S. Government, J.P. Morgan Asset Management.
- Ongoing easy monetary policy – low interest rates and bond purchase programs around the world continue to be inflationary for asset pricing levels and will likely contribute to broader inflation as the macro economic environment recovers.
- Vaccine rollout – as the high efficacy vaccines get rolled out across the world during 2021, this should enable economies to re-open and support a strong rebound in economic growth.
- Improving employment – in the US, the unemployment rate has already reduced to 6.2% after peaking at 14.8% in April 2020 but still remains well above the pre-pandemic level of 3.5%. A normalising job market could put upwards pressure on wages and improve the financial position of many households, leading to increased consumer spending.
- Consumer confidence – consumer confidence likely improves moving forward due to the improving job market, impact of stimulus programs and benefit from accumulated savings through the pandemic.
- Political environment – moving from a more pro-corporate environment (under Trump) to more pro-labour (under Biden). In particular, the potential for a minimum wage increase in the US could be a big inflationary driver.
- Unwind of globalisation benefits – we may see an unwind of some of the benefits of manufacturing in low cost labour countries as companies look to shore up their local supply chains and reduce the risk of tariffs.
- Increased ESG focus – the increasing focus on environmental and social responsibility related factors could drive increased costs in certain areas, including wages, employee safety, supply chain and sourcing costs, and costs to meet environmental targets.
- Supply and logistic bottlenecks – we are increasingly hearing from many corporates about supply chain issues, logistic bottlenecks and delays in sourcing parts and finished products. As an example, the dry van rate per mile (proxy used to gauge spot logistic costs), is up 45% since the start of 2020 and up 90% since the March 2020 trough.
- Input cost inflation – we are seeing widespread inflation in input costs from a sharp increase in various soft and hard commodity prices. The S&P GSCI Index, which tracks a basket of over 20 soft and hard commodities including oil, gas, gold, copper, aluminium, wheat, corn, cotton, cocoa, cattle etc., is up 12% since the start of 2020 and up over 100% from the March 2020 trough (now back close to 5-year peak levels) – see chart below.
The combination of factors outlined above certainly mean there is a material risk of inflation spiking in the near term, which will likely lead to increased fears around rising interest rates. However, there is still uncertainty around how sustainable any increase in inflation will be and what this means for interest rates. From a long term perspective, there are still many structural factors that could keep a lid on inflation concerns, including ongoing efficiencies from automation, technology, globalisation, and low cost sourcing etc.
Market expectations for inflation are rising
A key market-based measure for expected inflation is the breakeven inflation rate. This is the difference between the yield of a nominal bond and an inflation-linked bond of the same maturity. The US 5 year breakeven inflation rate has been climbing quickly in the past few months and recently hit its highest level in the past decade (see chart below). This highlights the market is certainly starting to expect increased inflation.
Interest rates – the long end of the yield curve is rising
The US Federal Funds Target Rate remains at historical low levels (see chart below) and we are unlikely to see rate hikes in the next 12-18 months given the Federal Reserve Chairman, Jerome Powell, has made it very clear that the Fed intends to continue with more accommodating monetary policy and a willingness to let inflation run above the 2% long run target for a more extended period than usual.
While it is unlikely we will see the US Federal Funds Target Rate raised in 2021, we have already started to see the yields of longer dated treasuries rise. For example, since August 2020 the yield on the US 10-year Treasury note has risen from 0.50% to 1.64%. This remains low relative to historical levels but the rising trajectory is already creating some concern in a market that has arguably been pricing in very little risk of higher rates. Given some investors may use the yield on treasury notes as a key input in determining their discount rate used in valuation models, any rise in yields may have a material impact on valuations and thus share prices. In recent weeks, this impact has already started to be felt in the market, particularly for companies where much of their value is predicated on long dated cash flows, including many unprofitable technology companies.
Performance of the perceived beneficiaries from a rising inflation and higher interest rate environment
While we are not totally surprised to have seen a shorter-term gravitation towards the perceived beneficiaries from a rising inflation and higher interest rate environment, we have already seen some quite extreme movements in the share prices of many of stocks/sectors exposed to this theme. We believe the market is arguably already factoring in a lot of the potential upside for companies with more sensitivity to an improving macro outlook.
In particular, since the start of November 2020 when the positive vaccine data started to emerge, we have seen strong outperformance from many of the cyclical or rate sensitive parts of the market. To illustrate this point, we have extracted performance for some of the GICS Industries that are typically perceived to be beneficiaries in this type of environment i.e. industries such as energy, metals and mining, banks, insurance, cyclical industrials etc.
The table below highlights that the average USD return of the selected GICS Industries is +47% since the start of November 2020 and +120% since the March 2020 trough. This compares to overall MSCI World Index returns of +23% and +77%, respectively.
Within our global equities (Global Core) portfolio, we have approx. 6% weighting to the GICS Industries listed in the table above vs. ~25% weighting in the MSCI World Index. Collectively, our underweight to these parts of the market have contributed to our portfolio returns lagging the strong market returns since November 2020. This is consistent with what we would typically expect during the early stages of a cyclical recovery. However, we would argue that many of the companies within these industries are of lower quality in nature and arguably don’t have the type of attributes that drive long term sustainable earnings growth, which we view as being one of the key drivers of shareholder returns in the long term.
In the short term, a big component of the returns for many of the cyclical and rate sensitive stocks has been driven by a valuation re-rating. Once this re-rating occurs, we believe the focus will inevitably start shifting back to more fundamental factors such as long-term earnings growth, balance sheets and cash flows. While we acknowledge that a macro economic recovery should present tailwinds for certain companies in these industries, we still think it is very important to focus on the quality of the underlying businesses. Similar to what we have seen in the past, during the early stages of the current cyclical recovery we have seen a ‘rising tide lifting all boats’. This has driven the share prices of many poor-quality companies to levels that may not be sustainable, especially if the economic recovery is not as smooth as is currently anticipated.
Portfolio positioning in the current environment
Given the inherent uncertainty in predicting exactly how the external market conditions will transpire, we aim to construct our portfolio in a way that we believe ensures we have a diverse contribution of returns from stocks and sectors with varying attributes and drivers. This means that we have exposure to many quality companies that we see benefiting from an improving economic outlook over the next couple of years, while being careful to avoid many of the key fundamental and valuation risks that are becoming more apparent in lower quality parts of the market. Additionally, we also have exposure to defensive parts of the market which we believe should continue to deliver compound earnings growth regardless of how the external environment plays out.
If fears over rising inflation and higher interest rates continue to grow, we believe this could be a catalyst for market participants to return their focus to some of the key fundamentals which have arguably been ignored during the early stages of the cyclical recovery. In our view, some of the most important company attributes for investors to consider during periods of rising inflation and higher interest rates include:
- Pricing power – in an inflationary environment one of the most important attributes for a company to possess is good pricing power (i.e. the ability to pass on rising costs without materially impacting volumes). A key focus of our investment process is identifying companies with sustainable competitive advantages and pricing power and therefore we believe we are well positioned in this respect.
- Strong balance sheet – during periods of low/negative interest rates and ‘easy money’, balance sheet strength is often ignored. If we move into a rising rate environment then we will likely see much greater focus placed on balance sheet strength. A company’s balance sheet is one of the six key quality factors we assess before investing and this means our portfolio always has far less leverage than the market.
- Valuation risk – in a rising rate environment, one of the single biggest risks to equities is ‘valuation risk’, especially the parts of the market with more extreme valuations or valuations based mostly on long dated cash flows (i.e. unprofitable growth companies) which would likely be hit harder due to the influence that a rising discount rate has in lowering the present value of forecast future cash flows. BAM’s valuation discipline and focus on profitable companies with visible cash flows positions us well should concerns over high valuation stocks increase.
In addition to the attributes outlined above, we also believe having exposure to the small and mid-cap segment of the market is a key advantage in an improving macro environment. The below chart highlights the performance of the SMID asset class (as represented by MSCI World SMID Cap Index) coming out of the dot-com bust and the GFC, and we are already seeing similar outperformance play out for small and mid-caps since the COVID trough in March 2020.
Portfolio performance during historical periods of rising rates
BAM’s Global Core portfolio has an 18 year performance track record (inception January 2003). In this timeframe there have been two distinct periods where the US Federal Reserve has increased interest rates; 1) 2005-2007, and 2) 2017-2018. During both of these periods our portfolio generated strong outperformance versus the benchmark (MSCI World Index) – see chart below.
Source: Bloomberg, Bell Asset Management
- The threat of rising inflation and higher interest rates is a key risk factor that we believe all investors should be considering. As the risk increases, investors are likely to refocus more on company fundamentals and valuations.
- Looking forward, we believe our ‘quality at a reasonable price’ investment strategy is positioned well to outperform in an inflationary and rising rate environment due to exposure to companies with good pricing power, strong balance sheets and highly visible cash flows, and less exposure to companies with high valuation risk.
- During the two distinct periods of rising rates over our 18-year track record (2005-2007 and 2017-2018), BAM’s Global Core portfolio has outperformed strongly versus the market in both periods.
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This document may contain forward looking statements and such statements are made based on information BAM holds as reliable; however, no guarantee is given that such forward looking statements will be achieved. BAM has made every effort to ensure the accuracy and currency of the information contained in this document; however, no warranty is given as to the accuracy or reliability of the information. Past performance is not necessarily indicative of expected future performance.