Markets assume that inflation will fall so the Federal Reserve will not take harsh steps to tame the rising cost of living. Inflation will remain 'higher for longer' for at least the next year.
By December 2021, central bank governors had finally realised what we had been telling them since the Covid-19 pandemic began: inflation was never transitory, and never could be, when governments and central banks were pumping huge sums of money into the economy. They are changing tack on monetary policy at last.
Central bankers are increasing rates to maintain their credibility and fight inflation, but a small hike may not be enough to tame high inflation. With US inflation already touching a 40-year high of 7%, it's not clear they will do enough as politicians, the Federal Reserve, European Central Bank and Bank of England fear recession, unemployment and displeased voters more than higher shopping and heating bills. Tapering their bond buying and increasing interest rates slightly will not be sufficient either. That's not 'normalisation' of monetary policy; it is the removal of emergency Covid-19 measures.
Higher inflation has not hurt the largest global companies but many more have struggled. The share price of the average company has gone sideways as firms havenâ€™t or cannot pass on inflation in full to consumers yet. That will happen this year and those smaller players should do well as growth is still positive.
Many companies are beating expectations and delivering positive profit as the chart below shows. The data looks positive for the year ahead as economies continue to grow. Even so, expensive equities will come under pressure as monetary policy tightens. Cheaper stocks that can grow production, sales and prices will do well.
We are nearing the peak of the business cycle but have not yet crossed it. Businesses remain confident in most countries, according to purchasing managers’ indices. When it comes to performance however, passive investors who accept the return of the index will be hampered by expensive valuations.
At the risk of being repetitive, we are still positioned for baked-in inflation for a good two years at least. Overly-expensive and speculative stocks that lack real earnings are falling out of favour, while prospects are stronger for companies that profitably make products which people and businesses actually need; these are the companies that have the power to up their prices.
Investment view: how to inflation-proof your portfolio
Many companies are delivering bigger revenues and profits as global economies recover. Not every share price will reflect that, as inflation will hit companies in different ways.
Supply chain issues and Covid-19-related staffing problems are being overcome. That should be good for profits and share prices. But there is a significant caveat: inflation is real and many stocks are expensive. Investors will quickly ditch speculative stocks and companies that may not deliver on their promises. Be careful where you invest next.
Inflation will continue to eat away at profits and the value of companies that cannot pass on increasing costs. With US input inflation close to 15%, companies will have to bite the bullet. That will benefit the shares of those companies with pricing power, but not those without.
As you can see from the chart below, economic surprises have stabilised. Economic data was extremely volatile and disappointing last year but is currently beating expectations. That is good for companies and confidence, leading to more investment to bolster productivity and future profits.
Higher interest rates will also affect how fixed income investors react. Inflation is bad in the short term, so we protect portfolios by avoiding government bonds, holding more high-yield bonds. As the impact of inflation washes through the market, we benefit from higher rates in the longer term.
Real assets tend to perform well in an inflationary environment as investors look for dependable investments that are less exposed to the economic cycle. Property and infrastructure are set to benefit. Office, warehouse and factory rents will increase each year, based on the rate of inflation, helping to protect the real value of your wealth. If their shares are sensibly priced now, companies that make real products that real people want to buy will prosper.
The US government and the European Union are committing trillions to the transition to a sustainable economy and protecting communities from the increasingly extreme impact of climate change. The UK government has promised to level up spending between the rich south and the poorer, neglected north.
We have reached the point where additional government spending will only create more inflation. Though investment in solar power, electric vehicles, charging stations and other green initiatives is necessary, this too is inflationary. With shocking gas and electricity bills landing on doormats everywhere, investors might be tempted to look to utilities to protect their wealth. However, the cautionary tale of EDF, where the French government forbade the energy giant from passing on higher costs to the consumer, shows that political intervention and price caps are a risk for investors to contend with. As ever, the careful selection of investments and diversification are required to navigate this high inflation landscape.
The information and opinion contained in this Monthly Commentary should not be treated as a forecast, research or advice to buy or sell any particular investment or to adopt any investment strategy. Any views expressed are based on information received from a variety of sources which we believe to be reliable but are not guaranteed as to accuracy or completeness by Sanlam. Any expressions of opinion are subject to change without notice. Past performance is not a reliable indicator of future results. Investing involves risk and the value of investments, and the income from them, may fall as well as rise and are not guaranteed. Investors may not get back the original amount invested.