Inflation: the forgotten risk
Since the start of the year, equity and bond markets have continued to recover the losses experienced at the end of 2018, and the global economy is enjoying low unemployment and good (albeit slowing) earnings growth. While we can appreciate these positive conditions for now, it’s our job to look ahead, identify potential risks and position client portfolios accordingly. This month we discuss inflation, and why it could prove to be a costly forgotten risk.
Should we heed the history of inflation?
We need to go back as far as 1980 to see US inflation rates rise above 10%. That’s a whole generation of investors who have never experienced the consequences of rapidly escalating inflation. During the late sixties and early seventies, the economy was in a similar place as it is today – low inflation, very low unemployment and persistently low interest rates. Back then, sudden wage growth caused inflation to soar from 3% to 10% in less than two years, and policymakers were caught sleeping at the wheel.
“While global growth appears to be slowing, it is still above trend, which could drive inflation higher. We must consider the risk of a potential inflation shock.” Philip Smeaton, Chief Investment Officer.
Source: Bloomberg, Congression
Managing inflation risk
Today, markets are not expecting the same outcome, and investor sentiment is anchored in the continuation of this low-inflation, low interest rate environment. But we think it’s important to be mindful of this risk, and position client portfolios accordingly. To do this, we ensure portfolios have exposure to some investments that are linked to inflation, such as infrastructure funds, inflation-linked bonds and companies with sought-after products (and therefore the power to increase their prices if necessary). Such investments are also a natural hedge against volatile markets, so we think they make a prudent choice for clients looking to protect themselves from downside risks, while still being able to realise the benefits of current market conditions.
Investment view: growth versus value stock
Investors often talk about choosing between growth and value stocks. So, what’s the difference? Growth stocks are companies that are expected to expand quickly. They reinvest their earnings to fuel their ambitious growth strategy, investing in new infrastructure, technology, people and/ or acquiring other businesses. Value stocks, on the other hand, tend to be businesses with limited internal investment opportunities and potential risks that concern investors. When investors are overly fearful of such risks, this creates a margin of safety, with the shares then being unfairly discounted by the market. If the margin of safety is large enough, then even if some of these well-flagged risks do occur, the share price can rise anyway, and the savvy investor can make a return.
Which is best?
When economic growth is strong, this benefits all companies and in the good times strong demand means that business risks are less likely to manifest. Any business is easier to run if the company is growing. In slower growth environments, companies with less growth opportunities struggle as they must cut costs to stay competitive and disruptive technologies tend to take market share. As this slow but steady economic expansion progresses growth stocks have delivered against expectations, while value stocks have struggled.
As Chart 1 shows, growth stocks are currently looking expensive relative to value stocks – though you would have been happy holding them over the last eight years. Chart 2 shows that the growth outlook for value stocks has actually improved. At the same time, the margin of safety relative to growth stocks is the largest it has been since 2005. This means that investors who can find great businesses among value stocks could reap strong returns.
Chart 1: Source, Sanlam, MSC1, Bloomberg
Chart 2: Source, Sanlam, MSCI, Bloomberg
The Sanlam view
We think investment should be about balance and diversification. The likelihood is that both growth and value stocks will have a place in every client’s portfolio, but the emphasis will depend on their individual objectives. Investors are currently shying away from business risk and are favouring ‘safer’ stocks. Inevitably there will be some strong companies that are swept along with this cautious sentiment, so we focus on finding these opportunities and unearthing hidden gems.