DB Wood Team

23rd July, 2021

Blog, IC Insights

Presenting the inflation tug of war, sponsored by COVID…

Markets have been described as a weighing mechanism for future outcomes. They generally reflect the consensus of what people expect to happen, though in reality there are many differentiators on a micro level, so it is necessary to drill down country by country and sector by sector. In addition, different indicators, such as interest rate movements, mean different things for different asset classes, (stocks versus government bonds for example). Suffice to say, there is lots to consider in order that our portfolios can protect against market losses yet still make a nice positive return!

Inflation has been the biggest talking point in investment markets over the last few months. From our experience however, investors are often taken by surprise by something they are least expecting, so be assured we are not going to be broadsided by what, from a media perspective, appears to be the only game in town. Our view remains that COVID-19 continues to slow the impact of inflation, as economies struggle to bounce back. Prices will rise in certain sectors, due to supply disruptions or bottlenecks (possibly driven by the new ‘pingdemic’), but these will also slow growth overall by denting consumer confidence.

Where are we now? Well, a year ago, the COVID-19 pandemic crushed prices in many parts of the global economy. As expected, that has created inflation 12 months on as the economy reopens and rebounds. Looking at the facts, and using the US as an example, June’s “headline” consumer price index, including everything the government puts in its representative basket of products and services that people buy, stands at 5.4%. That’s the highest level in 30 years barring one month in the summer of 2008 when oil nearly reached $150 per barrel. If you exclude food and fuel, inflation still comes in at 4.5%, and even when the most extreme movers in the basket are stripped out, it stands at 2.9%, the highest level since 1992 (barring that few months of very expensive oil). It’s no wonder equity markets have shifted to sectors that should benefit from this price growth.

Those numbers don’t seem to support our thesis, but our view is that its running hot for the moment and will fall back within an expected low range over the next 12 to 18 months. Bond markets and economists have started to agree with this view as well, as they see inflation not only coming under control but eventually falling to levels lower than before the pandemic hit. The bond market’s best estimate of the average inflation rate for the next 10 years stands at 2.3%. Bond prices, that generally do badly when inflation rises, are higher than their average for the last decade. They aren’t worried.

Either bond investors remain confident that Central Banks can keep rising prices under control, or they’re worried the economy won’t keep growing fast enough to push inflation numbers higher. Those concerns are definitely increasing as the delta variant shows its ability to slow economic reopenings.

So, markets in early Q3 are feeling unsettled. More recently, in stocks the COVID damaged stocks have stuttered after having had a good run for several months, and the quality stocks that did well last year have resurfaced as the benefactors. If millions of people are isolating, and millions more cautious about doing things, the growth rebound will be severely restricted. This COVID induced inflationary tug of war is certainly challenging market direction, with gyrations one way and then another, though we remain confident that our positioning is diversified enough should we be wrong and have enough flexibility to adapt when the opportunities show up.

In July so far, we have a firm grip on the rope, protecting the downside whilst eking out rewards where possible, though we know we will likely need to heave a lot more over the months ahead!

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