Managing capital in an uneven economy

When the waterholes were dry, people sought to drink at the mirage.

Evelyn Waugh, Brideshead Revisited

Everyone is talking about inflation. It’s the big fear that’s rattling markets and giving those that can remember the 1970s a collective sense of deja vu. It’s a reasonable fear; when those in the UK are faced with dry petrol pumps, rising food prices and talk of an oncoming energy crisis it’s no surprise that the gloomier pundits are muttering about a “winter of discontent”. But the picture from an investment perspective is neither so straightforward, nor is it necessarily so bleak. If you can unpack the slightly more complex dynamics that are driving market sentiment now, then you can see that there are clear and practical ways to manage capital accordingly. That’s what we’re going to explore here.

The great disconnect

There’s absolutely no denying that inflation is an important economic metric, but context matters, and it just so happens that in today’s world that context is very strange indeed. In financial commentary you often hear the phrase “the economic cycle”, but in reality it's something of a misnomer; there isn’t one cycle, there are many, and they tend to move together like cogs in a machine. Economic growth drives the monetary policy cycle, and both combine to drive the asset price cycle. Today, central bank intervention, to prevent a financial meltdown has effectively plucked these cogs apart. We’re seeing a classic mid-cycle slowdown in economic growth, but – if you’re going by the Taylor Rule – we’re right at the beginning of the monetary policy cycle, and the disconnect between those two has spun the asset price cycle right to its tail end, where valuations are at extreme highs. It’s a highly disjointed picture, and that’s behind so much of the turbulence we’re seeing in markets today.

There’s absolutely no denying that inflation is an important economic metric, but context matters, and it just so happens that in today’s world that context is very strange indeed.

Inflation: a rising tide?

The net result of having policy unmoored from economic growth is the risk of inflation, both in asset prices, and in the real economy. And on the face of it, current inflation figures are startling. In the US, the August personal consumption expenditure (PCE) data – which shows the prices of what people buy rather than just the prices at which companies want to sell – show the biggest increase that we’ve seen in 30 years. In the UK, the Bank of England has warned that inflation could top 4% going into next year, and Eurozone inflation has hit the highest level in 13 years. Markets are reacting as you’d expect; we’re seeing growth stocks roll over in favour of those who can handle a bit of pricing pressure, like energy companies and raw material producers.

The fact that the economic recovery is slowing is creating even more downward pressure, and is stoking talk of the dreaded “stagflation” scenario, where inflation picks up while growth slumps. It’s an ugly prospect to be sure, but it’s not necessarily one to become excessively fixated by. Yes, growth is slowing in the world’s two largest economies, but that’s largely to be expected as the stimulus measures start to wind down and normality is allowed to resume. After all, it’s not as if we were in a high growth environment before the pandemic hit; growth was slow to moderate, and inflation was consigned to financial asset prices and economics textbooks.

“Water, water everywhere, nor any drop to drink”

So today we have moderate and slowing growth, a pickup in inflation, and high asset prices, which is a difficult mix for investors to navigate. Indeed, one of the interesting ironies of central bank intervention, is that pouring excess liquidity into markets doesn’t create more investment opportunities, in many ways it actually does the opposite. When central banks buy bonds it dries up the yield, which means investors have to quench their thirst for it elsewhere, piling into riskier assets and driving up prices. This has happened to such an extent that some fear that a moment will come when investors collectively decide that – in Waugh’s terms – they’re drinking from a mirage. That’s when you see the so called “Minsky Moment”, where bullish sentiment suddenly sours. The argument against that scenario is that many of the investors forcing up prices aren’t necessarily optimistic, they’re hamstrung. There are plenty of investors out there who are mandated to produce monthly yield, so come hell or high water they have to eke out income from whatever sources they can find, whatever the cost.

Now rule number one of investing is much like rule number one of budgeting, don’t buy what you don’t need. So the first thing to think about in this environment is whether it makes sense to own bonds. They do offer protection against a deflationary bust, but that’s looking like less of a risk as time goes on, and there are more sophisticated ways to manage risk. To start with, there are options and hedge overlays, both of which allow you to carefully position portfolios according to very specific risk parameters. Secondly, there is correlation. The idea of uncorrelated assets is a slippery notion; correlations are fluid not fixed, and crises have a horrible habit of radically reshaping the relationships between asset classes. But we do know that when inflationary pressures are the key cause for market turbulence, gold and commodities are likely to provide decent protection.

Glass half empty or glass half full?

The good news is that there are ways to protect portfolios against inflation. The better news is that it’s still surprisingly cheap to do so. Despite all the fear and noise, not many investors are buying inflation protection at the moment, and we think that medium term inflation is particularly under-priced. The inflationary forces building up in the system may or may not be transitory, but underneath that there are structural pressures building from higher government spending. That’s a key risk to watch.

On a general note, there are still reasons for optimism; vaccine take-up rates are increasing, particularly in Emerging Markets, and despite a slowdown in growth we still have a huge wave of US government spending in the pipes, so economic conditions going into 2022 may well improve. There’s no denying that conditions are far from straightforward for investors today, but investors with long time horizons and no need to chase yield are amongst the best positioned in the marketplace to navigate these choppy waters.

The Taylor Rule

Taylor's rule is a mathematical formula intended to serve as a guideline for the U.S. Federal Reserve and other central banks for adjusting interest rates in response to changes in economic conditions such as inflation and the unemployment rate. According to the rule, there are three determinants of real short-term interest rates (i.e. interest rate adjusted for inflation).

  1. The targeted level of inflation in relation to the actual inflation levels.
  2. The actual levels of employment in relation to full employment.
  3. An interest rate that is appropriately consistent with full employment in the short term.

Investment Strategy & Outlook

Market sentiment is heavily tied to health and policy, and easy financial conditions are making longer term returns harder to find. This makes effective diversification the single most important factor in both risk management and return generation today. Our approach is geared towards maintaining maximum upside potential without overly exposing the portfolio to macroeconomic forces. We have seen this play out effectively so far this year; our value equity tilt and minimal bond exposure helped power performance while the market was fixated on strong growth and inflation, but we were still able to protect capital while the market shifted sharply back towards defensive assets with longer duration characteristics.

While we are positioned to steer our clients’ portfolios smoothly through shorter term dynamics, ultimately, we are long term investors, and that leaves us with important questions to consider. Will central banks keep making it easy for governments to spend? Will that stimulus build up to create longer term inflationary pressures? And, crucially, how much higher can asset prices climb before they correct?

Taking these in turn; we do think that financial repression is a likely environment facing multi asset investors over the coming years. To reflect this view, we don’t advocate that clients have exposure to traditional government bonds, except in the case of Chinese bonds, which have a positive real yield, a policy mix which is more supportive of creditors, and will benefit from the loosening of foreign investment restrictions into China. While there are forces working against Chinese assets in the short term, we think that there is a positive longer term case for both Chinese equities and bonds. Valuations – a key area of concern for asset prices globally – are relatively more attractive than in other advanced economies, China is becoming increasingly dominant on the global stage, and it is home to some of the most advanced technological innovation in the market today.

As for equity valuations more broadly; with trillions of dollars’ worth of economic stimulus still in the pipes, there is still a good deal of support for asset prices, but there is no doubt that parts of the market look expensive, and the longer this persists, the greater the risk becomes. Our approach is to maintain exposure to upside equity risk, while adding portfolio protection at the margins. By working with both direct equity exposure as well as put and call options, we provide some protection against the risk that markets correct, but also the risk that they do not. We are also maintaining our clients’ tilt towards value equities, equities outside of the US, and active managers who can capture the opportunities created by market price dislocation.

Lastly, in this environment of heightened risk and market dislocation, we think that active management is key. Over the past few months we have been increasing our focus on active managers who can be nimble in times of market stress. We have also increased our clients’ positioning in alternative strategies across a broad range of investments, including gold, commodities and active strategies with idiosyncratic drivers of returns, such as long/short strategies, and macro hedge funds, all of which have liquidity on at least a monthly basis.

All information and opinions expressed are subject to change without notice. Advice is given and services are supplied by Capital Generation Partners LLP and its affiliates (“CapGen”) on the basis of our termas and conditions of business, which are available upon request. No liability is accepted or responsibility assumed in respect of persons who are not clients of CapGen, unless expressly agreed in writing.

This does not constitute investment advice or an offer, contract or other solicitation to purchase any assets or investment solutions or a recommendation to buy or sell any particular asset, security, strategy or investment product.