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Inflation – A New Chapter?

For financial professionals only

One of the risks we are tracking in our management of portfolios is inflation. Our Parmenion mantra of maintaining a well-diversified approach makes us well positioned to cope with the potential challenges, but it is worth digging into the detail of this year’s inflation challenge, given how topical it is right now.

Background

Since 1998, the Bank of England have managed monetary policy to ensure inflation remains around 2.5% per annum.

After the horrors of the 1970s and early 1990s, when inflation and high interest rates ravaged the real value of savings and fixed interest holdings, . Inflation came under control and then successive rounds of QE since the Financial Crisis in 2008 and under Covid have underpinned the returns on bonds.

where asset prices are based on fundamental analysis (not central bank policies) and where companies can experience increases in costs that they’re unwilling or unable to pass on to the consumer.

UK Inflation – on the rise?

UK Inflation rose by 2% in the year to July, 0.5% lower than June and 0.3% lower than expected by economists polled by Reuters.  However, there were technical reasons for this lower than expected rise and the Bank of England is expecting inflation to be temporarily trending at around 4% a year by Christmas.

Source: Bank of England via FT

Pressures on prices

Prices are rising because of various factors. Since Brexit and with Covid, a significant number of European workers have returned home which has reduced the pool of labour, notably among lorry drivers. As a result of Covid lockdowns, industries such as hospitality and entertainment have been shut down causing staffing shortages as the economy reopens. This is leading to increases in real wages to attract the staff needed to reopen pubs, restaurants, hotels and cinemas. The post-pandemic recovery has led to shortages and bottlenecks in basic materials, components and other commodity prices, all pushing up prices, amplified by transportation difficulties. A new approach to ‘flexible working’ has contributed to increases in house prices, particularly outside of city centres, for homes with spacious gardens. These factors combined contribute to  a knock on effect on the cost of goods and services.

Impact on equities

Crucially, pressure on business costs has not yet been fully passed on to the consumer via higher prices. In turn, this could impact equities as well as bonds.

The chart below looks at the gap between US producer prices and inflation, set against movements in the US S&P 500 equity index. The orange and grey bars indicate the spread between producer price increases and inflation. Historically, when producers don’t pass on higher prices as shown by the orange bars, company profitability falls, and the stock market adjusts on the evidence of reduced profits.

Source: Real Investment Advice

Rate hikes?

The Federal Reserve has recently introduced a new policy of ‘average inflation targeting’ which essentially allows inflation to consistently run higher than the 2% target if it holds to that level on average over time. The idea is to avoid the economy stagnating. The danger is, if inflation gets out of control, rate hikes will follow, and the market will react badly.

The tapering challenge

In addition to controlling inflation, central banks now face the task of ‘tapering’ monetary support without causing another shock to the economy. This will likely mean small and gradual reductions in liquidity support, largely unobserved by market participants. The risk here is that markets might not recover the ability to stand on their own two feet quite as quickly as expected.

The Parmenion view

The Parmenion investment team are ever conscious of the potential impact of rising inflation, and reactive central bank policy, on all asset classes. We examine structural changes to identify each asset class’s long term risk and return characteristics. We then look to optimise our exposure through the combination of assets we create in our Strategic portfolios.

Meanwhile, our Tactical portfolios let us react to prevailing market conditions over a shorter to medium term horizon and adapt our asset allocations accordingly. In response to the inflation risk, PIM Tactical Active portfolios are now significantly underweight in UK Gilts but overweight Global Strategic Bonds, where our managers have the flexibility to capture credit opportunities while taking less duration risk (than offered by Gilts) as conditions evolve.