Jonathan Marriott, Chief Investment Officer
Over the last 50 years, the MSCI World has averaged 7.5% total return per annum. By contrast, after the Consumer Price Index (CPI) print, the Nasdaq stock market index rose by 7.3% in a few hours. The headline CPI number came in at 7.7% with core (excluding food and energy) at 6.3%. This is down from 8.2% and 6.6% respectively from the previous month and slightly below the market expectations. That said, it is still well above the Federal Reserve (Fed) 2% target. So, while this was a better number, this does not mean the hiking cycle is over.
The market move may have been helped by comments from a number of Fed officials suggesting to slow the pace of rate rises. It is important to emphasize that this would be slowing rates, not stopping or cutting them. The Fed still seem set to tighten further in December, but this is likely to be 0.5%, rather than 0.75%. The two-year Treasury yield dropped from 4.60% to 4.33%, reflecting a potentially lower terminal rate. Algorithm based trading and short covering may have extended the move. This momentum carried through in Asian trading, helped by moves in China to ease some of the pandemic restrictions. As such, the Hang Seng Index was up 7.7% and the HS TECH Index was up 10%. Clearly the mood has changed, but I would caution that one swallow does not make a summer, and one inflation print does not remove inflationary concerns. For a continuation of the move, we may need to see more data confirming the decline in price pressures: the 2% target is still some way off.
For the UK, the fall in the dollar may help ease inflation, but Europe’s dependence on Russian gas post-Brexit trade arrangements and the fall earlier this year in the value of the pound may mean that inflationary pressures continue to come through for longer than the US. Those looking for instruments that have protected against inflation in the past may be disappointed by the price action this year and in the months to follow.
The last time we had inflation this high was in the 1970s and 80s. Gold, property, and when initially issued, inflation-linked bonds did well. However, this time gold price is down in dollar terms. Inflation-linked bonds have dropped dramatically and while property has held up so far, it may be about to see a sharp correction. The problem is two-fold: the dramatic rise in interest rates and the starting prices for these asset classes. If inflation continues at such levels, you may have to look elsewhere for inflation hedges.
The Retail Price Index rose 12.6% in the last year. March 1981 was the last time inflation was that high, which happens to be the month the first Index Linked Gilt was issued. Initially, these were only available to pension funds before becoming more widely available to investors. That first issue had a 15-year maturity carried a 2% coupon, so over its life span it paid inflation plus 2%. At the start of this year, a 10-year index linked gilt paid inflation less 2.9%, and today it only pays inflation less than 0.5%. So, the starting point is very different. In the US, 10-year treasury inflation protected securities pay 1.4% over inflation, so they look to be a better investment, however they have currency risk that would need to be hedged with associated costs factored in.
The other big difference is that in 1997, the Bank of England was made independent with a 2% inflation target, facilitating a more aggressive stance of raising rates to get inflation under control. The inflation-linked index has a duration of more than double the conventional gilt market, thus making it highly sensitive to interest rate expectations and moves. Given this characteristic, despite high inflation and higher inflation expectations, the iShares index-linked gilts tracker has fallen over 30% this year. Curiously, in order to get positive on the asset class as a whole, you would need to be positive on long dated gilts. This would probably need inflation expectations to be lower rather than higher. This could see conventional bonds out-perform. At the time of the first index linked gilt issue, the breakeven inflation rate, implied by the yield difference, was close to 10%. As it turned out, inflation averaged 5.4% over the 15-year life. Hence, on a buy and hold basis the 15-year conventional bond outperformed.
Gold has also been viewed as an inflation hedge and did well in the 70s after the US and came off the gold standard, but it peaked in 1980. It then halved in the next five years and did not regain its peak until 2008. While gold is positive in sterling terms this year, it is down in dollar terms. In fact, as inflation fell on Thursday, it rallied. The problem being that high interest rates weigh on gold that pays no interest. Residential property prices boomed in the 70s and early 80s, only dropping after tax relief on mortgages was cut in 1988. This was fuelled by demand from the post second world war baby boom. Rising heating costs and mortgage rates are expected to weigh on property prices in the months to come.
So, where do you go if inflation remains a concern? I suggest that following the selloff in wider equity markets, we will see further opportunities there. However, a selective approach is vital. Low leverage on the balance sheet will reduce the impact of higher rates. This combined with a business model where rising costs can be passed on to consumers will help selective equities to outperform. In bond markets, credit spreads have moved wider, and interest rate rises may be priced in. In this space, a selective approach is also appropriate favouring companies that can use earnings to improve their balance sheets and reduce their level of debt.
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