Inflation - defining Goldilocks

The problem with discussing inflation is that pundits can often get away with open ended predictions - “inflation will be higher!” – without saying how high, when it will come and for how long. Without specifics, it leaves the rest of us to interpret it by ourselves. And typically, most jump to the conclusion that inflation will spiral out of control.

At 7IM we want to be clear on what we’re saying. We don’t believe inflation will be too hot or too cold but settle in a ‘just-right’ range. And the expectations we lay out below, aren’t just about the next year, but an average of the coming few years (3-5 years). In reality, that is the time horizon that matters for markets and, despite the near-term cost-of-living stresses, matters most for the economic outlook.

• Too cold is unlikely (0-2%) – given how inflation has gone recently, we’re not struggling to convince people that a return to the pre-Covid inflation levels is unlikely!
• Too hot is not as hot as you might think (4-8%) – most people jump to the conclusion that high inflation has to automatically mean a return to the 1970s. The reality is that free markets, globalisation, technology and demographics make double-digit inflation an extremely hard outcome to generate. More likely ‘high’ inflation should be defined as mid-single digits. Still bad, but less scary.
• Goldilocks (2-4%): this is the outcome we expect. Enough to encourage economic dynamism but not enough to damage the economy. A little inflation encourages economic activity, which is why central banks have a positive inflation target, and why the last decade has seen sluggish growth.

3 reasons not to worry:

1. How high can energy prices go?
We aren’t going to try to comment on the future direction of geopolitical events. But it’s hard to ignore their part in driving inflation concerns. First, regarding the natural gas crisis it’s worth noting that prices are down 50% from the peak. Yes, gas is still nearly triple the levels seen during 2020 but this is already in the inflation numbers. It’s also worth noting that these price rises weren’t just down to geopolitics – a whole host of global issues constraining supply; cold winter last year in Europe draining storage, low wind over the course of the summer, and increased demand from Asia after the reopening, have all played their part. Each of which is unlikely to play out again – and all three are very unlikely.

It is important to remember how the inflation basket works – it records price rises, not price levels. Looking at oil prices, to the end of 2021, we saw oil prices double over the year. In order to see a similar impact on inflation we need to see oil prices double again, to levels we have never seen before; close to $200 a barrel. Without a sustained rise above 2008 levels, oil price rises (and hence, inflation) may have already peaked.

2. The average person doesn’t spend that much on energy
We can see the impact that rising energy prices has on consumer prices. Just look at the period between 2003-2008 – we saw oil prices rise by around 500%. Yet, look at the inflation actually experienced by the average UK consumer and it barely punched above 5%. And even when oil prices nearly reached those $100+ levels again, between 2011-2014, inflation was pretty unbothered. The reality is that energy prices don’t matter as much as perceived wisdom suggests.

3. 7IM portfolios stand to benefit from inflation
Taking a step back, let’s remember that some level of inflation is a permanent feature of our lives – we’re all used to it. As a result, economies adjust, policymakers react and markets price in this feature of the global economy. And 7IM construct portfolios for this reality, that there will be some inflation. We do so by making it a key building block of our Strategic Asset Allocation – the foundation of all our portfolios.

How is inflation factored into the SAA process?

Many of our competitors will only look at the volatility and correlation characteristics of asset classes when building portfolios. Our starting building block for portfolios is our SAA, where we include the analysis of macroeconomic factors that we believe are key drivers of asset prices. There are a number of broad macroeconomic drivers – or risk factors – in the financial world, and different asset classes have different exposures. We believe duration, economic growth and inflation are the three most important (and pervasive) drivers of asset prices.

In terms of inflation, most investors want to preserve spending power. Save now, spend later. As prices of goods and services rise, they’d like their portfolio value to keep up. Many investors associate growth and inflation, assuming that you can’t have one without the other. However, there are plenty of examples of high inflation, low growth environments – the 1970’s in the UK was one such period. We want to make sure our portfolios are ready for those kinds of environments when constructing them. We do this by incorporating real-time measures of Consumer Price Inflation as well as oil prices into our construction process. Unlike the majority of our competitors, we therefore explicitly manage our inflation exposure as we believe this is one of the key economic risks our multi-asset portfolios are exposed to.

And again, this is not just academic, the chart below demonstrates the proof of concept. Our SAA continuously delivers CPI+ returns, in line with our clients’ expectations.

How the TAA can benefit from higher inflation?

A number of our existing tactical positions help protect our portfolios against inflation. I would highlight the four points below as providing the most protection. However, I would stress that these are not responses to higher inflation, they more considered positions based on our assessment of the economic environment.

• We are underweight bonds. Bonds tend to be hit much harder by inflation than equities. This is because the majority of bonds pay a fixed coupon. When inflation rises, the real value of this coupon falls. Bonds typically sell-off when inflation rises, equities tend not to take a hit unless inflation really takes off, and current inflation is still some way off that. Recent inflation figures are part of the reason we have seen bonds selling off.
• We are overweight cyclical equities. Cyclical stocks are stocks that are stocks whose price is more affected by macroeconomic conditions, hence they tend to follow cycles of an economy through expansion, peak, recession and recovery. Cyclical companies often involve consumer discretionary goods that have more income elastic demand, meaning people buy more of them when they have more money. This is the case at the moment: globally, consumers have more savings than ever before. Cyclical equities fare well in inflationary environments because pickups in inflation usually coincide with cyclical upturns. This is what we are seeing at the moment, strong economic growth, and higher inflation.
• We are fully invested. When inflation is picking up, cash is guaranteed to lose money in real terms. We hold low level of cash in all our portfolios.
• We are invested in healthcare. Demand for healthcare is price inelastic. This means that people don’t really care too much if the price of it rises, they’re still going to pay for their healthcare and suck up the higher prices. For healthcare companies, this is a good thing in an inflationary environment. Consumers are unperturbed by higher healthcare prices, and demand for healthcare doesn’t take a hit.

Ahmer Tirmizi
Senior Investment Strategist at 7IM