“The road is long, with many a winding turn…” That 60’s song lyric fittingly describes today’s markets, with global inflation the latest turn. Many investors have never experienced inflation like we’ve seen over the past year. In the U.S., gas prices have hit all-time highs, prices for meats, poultry, fish, and eggs keep climbing, and used cars have risen more than 30% compared to two years ago. In Europe, power costs have soared to record levels, rising over 200% in Germany, France, Spain, and the UK.
The cocktail of events that has influenced price rises is no secret. The unforeseen pandemic and the subsequent record stimulus, which increased the money supply in the U.S. alone by 40%, combined with labor shortages and tight supply chains, has had an overwhelming impact. The Russian invasion of Ukraine has added further inflationary pressure, especially the impact on oil. Brent crude breached $100 a barrel for the first time since 2014 – up 500% from April 2020 lows.
Figure 1: Bloomberg World Inflation Index
Source: Bloomberg. As of December 31, 2021.
Figure 2: Real Interest Rates are Deeply Negative in Developed Economies Difference between nominal policy rates and inflation
Inflation forecasts are the latest from Consensus Economics.
Source: Financial Times, Refinitiv. As of November 9, 2021.
As central banks in developed markets have been aggressively keeping rates lower, real rates are at historic lows and near-term increases are imminent. This comes at a fairly sensitive time for markets, which have benefited from artificially low rates and tepid levels of inflation for years. Global central banks must now embark on a path of tempering inflation at a time when global equity valuations are at historically high levels, similar to how they were in the late 1990s.
As if this weren’t difficult enough, monetary policymakers need to increase rates for the first time in memory amidst slowing economic growth, weakening consumer sentiment, an equity market that has been selling off, and a flattening yield curve. Businesses must navigate issues that have been on the back burner for years: cost pressures, inventory levels, and balance sheet leverage.
This clearly is not an environment for the faint of heart. The question on investors’ minds: Will markets ahead look more like the 1990s and the last 10 years when returns came easily, or more like the decade in between, where finding returns was a challenging task? Of course, no one knows the answer. In our view, the best approach is to “know what you own and why you own it,” as legendary investor Peter Lynch once said. That is sound advice and especially so during difficult markets.
Figure 3: Market Continues to Make New Highs Similar to the 1990s MSCI ACWI Index
Source: Bloomberg, FactSet. As of December 31, 2021.
Highlighted Downturns are the Total Return from peak to trough during those time periods.
The Index depicted is the MSCI AC World Index (SR) (USD), as defined in FactSet.
Figure 4: Tightening Time BofA strategists see risks from Fed tightening into an overvalued market
Source: Bloomberg, BofA U.S. Equity & Quant Strategy Research. As of November 9, 2021.
Figure 5: Global Long-Run Profit Persistence Parameter by Sector
Source: Bhangu, P.K. (2020), "Persistence of profitability in top firms: does it vary across sectors?", Competitiveness Review, Vol. 30, No. 3, pp. 269-287. As of May 13, 2020.
As quality growth investors, we feel good about owning companies with wide competitive moats, intellectual property (IP) advantages, strong brands, and robust balance sheets over capital-intensive, commodity businesses. If history is any kind of reliable guide, quality growth businesses were relative winners during the last persistent bout of inflation, from the mid 1970’s to early 1980’s. Admittedly, that’s a long way back, but in our view provides a relevant period of comparison.
Figure 6: Quality Growth at a Reasonable Price A sweet spot in past high and rising inflation environments
Past performance (actual or simulated) is not an indicator of future performance.
Source: Pachon, Wang, Inflation Hedge Portfolio. Data is up to November 1, 2021. Data: Credit Suisse HOLT, Bloomberg, Axioma, St. Louis Fed. All data shown for indicative purposes only.
Over the last couple of years, equity markets have oscillated between momentum stocks that have benefited from record stimulus and value stocks buoyed by rising interest rates and commodity prices amidst a recovery in corporate earnings and the economy from the COVID downturn. Whatever the hurdles in the road ahead, we believe that owning quality businesses can act as ballast in a well-diversified portfolio, helping investors navigate through challenging times.
The commentary is the opinion of Vontobel Asset Management. This material has been prepared using sources of information generally believed to be reliable; however, its accuracy is not guaranteed. Opinions represented are subject to change and should not be considered investment advice or an offer of securities.
Past performance is not an indicator of future results.
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