Poles apart: How the debate on inflation affects asset allocation

‘Polarisation’ is arguably the biggest global challenge today, seeming to encapsulate the zeitgeist of the 21^st Century. It affects global and national politics, attitudes to the climate challenge and social issues.  

Yet one sees evidence all the time that when issues are debated at a more granular level, or one seeks to understand why individuals hold a certain viewpoint, that the reality is so often much more nuanced. It is increasingly important in the time of tweet investment cases and partisan news headlines for us to always ask the balanced questions on behalf of our clients; to engage and get beyond knee-jerk assumptions. We mustn’t be afraid to admit that at times the definite answer on a specific debate is not yet clear.

The polarised debate in the sphere of ESG assigns entire sectors into the ‘good’ or ‘bad’ camp. In terms of carbon emissions produced both historically and today, the quantitative analysis is easy to do. However, widespread electrification, decarbonisation and establishment of green infrastructure requires a significant capex cycle. Some of the biggest enablers of that transition may be the same companies that in the legacy world were significant emitters. We need to take a holistic approach to assess the net effect of capital allocation decisions by individual companies. A polarised view risks missing the ability to facilitate and accelerate change.    

The pandemic has shifted the under-pinning of post global financial crisis (GFC) policy-making, initially driven by a desire to protect incomes during lockdown. The political impetus to close the inequality gap, and the urgency of the green transition agenda have become the wrappers for fiscal spending on top of aggressive monetary policy. Pandemic supply chain breakdowns and polarising geopolitics have combined to accelerate a reappraisal of globalisation. And the long-term effect on wage rates of changed attitudes to working patterns potentially reducing supply are an additional unknown.

Whilst some long-term deflationary factors stay in play, most notably the effect of digitalisation, the slowing or even reversal of trends in labour costs, fiscal spending and globalisation have brought the debate on inflation into sharp focus. Data exists currently to back the strongly held views of both ‘Team Permanent’ and ‘Team Transitory’ - but the very fact there is a debate demonstrates that something has changed. In financial markets, where the absence of inflation was the constant for over a decade, the ramifications of some inflation in the system for asset allocation are potentially significant.

One of the over-arching tenets of our investment philosophy is ‘take risk when you are paid to do so’. We recognise that we underestimated the impact of post GFC extreme monetary policy and the attendant re-pricing of long duration across asset classes. We have accordingly undergone a prolonged period of reflection, debate and challenge to recalibrate how we think about valuation in that context. Nevertheless, we stay true to our underlying philosophy that the price one pays for an asset is the key determinant of long-term returns. 

In a polarised world, valuations can move to extreme levels and sentiment can swing to the extent that one hears fund managers claim they will ‘never own’ a particular asset, sector or factor. Equally, extreme crowding into certain themes or characteristics can narrow market breadth into an extremely small group of companies. That creates pricing anomalies in a world that is more nuanced.

This does not mean abandoning every long-duration asset nor making a one-sided factor call – but does lend itself at the very least to more balance than has been evident in markets since 2008.

The polarised view had come to correlate entire sectors almost perfectly to the 10-year Treasury yield, whereas the recent earnings season revealed a huge range in management teams’ abilities to cope with higher cost bases. Long-duration assets are more vulnerable to upward shifts in discount rates so whilst those companies that can continue to grow and deliver cash and earnings can remain market stalwarts, the risks associated with non-profitable concept stocks may increase. Equally, sectors that had been regarded as generically ‘un-investible’ in an era of ever lower rates (such as financials, energy and short-cycle industrials) and aggressively de-rated now and have strong and weaker players within them priced with relatively little differentiation. That is fertile ground for active managers. 

We have been in a market regime where a particular asset quality/style has been dominant – most simply summarised as long duration – and best encapsulated by the technology space where excellent company fundamentals were combined with ever lower discount rates in a low growth low inflation post-GFC era. Valuations adjusted accordingly to a point where the probability of inflation was almost entirely priced out. There is now a healthy debate as to whether that era is changing, with the outcomes largely leaning toward more diversification across client portfolios. The good news is that the areas of the equity market that show a positive linkage to inflation have remained some of the most attractively priced in the market. Investors have been paid to put balance in their portfolios. The debate on the risk of inflation may be polarised but portfolio exposure need not be.