Wellian Weekly 15.02.2021

The return of inflation

Inflation has been the source of much debate this year. Recently, we’ve seen more speculation that the huge economic stimulus packages from governments and central banks around the world could kick start inflation again. It would be the first time we’ve seen meaningful levels of inflation in the UK since early 2019, and a sustained period of inflation has been almost non-existent since 2011.

What we have seen is that at the start of the pandemic, Year on Year inflation fell to almost zero. Since then, it has gradually been rising from a very low base, with the headline level of inflation expected to peak in the middle of 2021, when Year on Year inflation will then be positive once we have passed through the spike. Sectors such as energy will be big a contributor to these numbers as we have seen the oil price rise significantly from the lows seen last year.

If the recent low inflation trends continue, then recent investment trends are likely to continue as well. Inflation means money today is worth more than money tomorrow as the real value of an asset declines as inflation rises. This is essentially how a bond works with inflation. As inflation rises, the value of future bond payments falls, and the price of the bond should fall too. The low inflation seen in the past few years is one reason why bonds have performed so well. If inflation stays low, then you would expect that to continue.

What is true of bonds is also true of companies to some degree, although companies can raise prices to offset some of the effect of inflation. Most sectors, including traditional safer havens like utilities and consumer goods, have tended to do badly when inflation rises. That could be because rising inflation usually drives higher interest rates, which significantly reduces the value of future profits compared to current profits. That’s far more of a problem for businesses that are making only modest profits today but promise greater riches in the future.

Low and long-lasting levels of inflation also works for companies with large cash piles. Cash is very vulnerable to the effects of inflation because it generates little or no income. Companies that hold lots of cash on their balance sheet risk seeing the real value of that money shrink as it’s eaten away by inflation. Lower levels of inflation reduce that risk.

The promise of massive future profits, together with large cash balances, are two of the defining features of the large tech groups, for example. If inflation stays low, conditions for these sorts of companies should still be attractive and, along with bonds, are likely to stay strong performers. But what happens if inflation picks up?

The first issue of rising inflation rates is the possibility of a shift in favour of companies who are making profits today, rather than tomorrow. It’s the opposite of what we’ve mentioned above. This would be good news for companies that are usually considered ‘value’ stocks. In particular, it bodes well for companies with lots of assets and high amounts of debt. Inflation should increase the price of assets, but the value of debts stays the same.

The long period of low inflation rates and strong performance from tech and other growth stocks has seen the proportion of portfolios invested in these kinds of companies increase. If we’re on the cusp of a shift in inflation rates, then it should pay to make sure your portfolio holds a broad diversified range of investments. Lots of traditional ‘growth’ shares are great companies, and there’s no suggestion these should abandon them altogether. But having been neglected in recent years it could be worth reconsidering whether some value names deserve a place in your portfolio, they could be strong performers.

 

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