What rising inflation means for private wealth

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Is the UK inflation surge a temporary condition or something more serious? Either way, investors and wealth managers need to prepare for the tough times ahead.

UK inflation is expected to hit 5% next spring. The Bank of England believes it will then start to decline, approaching the 2% target within two years. Even so, the annualized inflation rate for 2022 is likely to be higher than it has been for more than 30 years – since Black Wednesday, when the country was forced out of the European exchange rate mechanism.

Inflation can be catastrophic, so it’s good news that independent economists seem to agree that the Bank is pretty much right. It’s not a permanent change, they say, although risks remain.

“In the sense that the forces that initially cause inflation are temporary, I think that’s a fair point,” says Rory MacQueen, senior economist at the National Institute for Economic and Social Research. The institute forecasts consumer price index (CPI) inflation of 4.4% next year and 3.4% in 2023 before falling below the target in 2024, subject to base rate hikes in 2022 and 2023. It forecasts annualized economic GDP growth of 4.7% in 2022.

At Capital Economics, UK chief economist Paul Dales agrees inflation is a temporary concern. Interest rates will peak at around 0.5% at the end of next year, he believes, while “fairly weak” economic activity will help inflation drop to around 2% by the end. from 2022. “Moderately higher interest rates should not derail the economic recovery,” says Dales.

So far, so good. However, MacQueen points to a wage-price spiral as a source of concern.

“If we see everyone factoring inflation expectations into their future plans, it could theoretically be self-fulfilling inflation, in which temporary factors lead to persistently higher inflation.” However, this is not the central scenario of his think tank, he notes. “We believe the bank will take enough action to get it on target, but perhaps not as quickly as some would like.”

Behind the curve?

Not everyone is so optimistic. Ruth Lea is an economist and economic advisor at Arbuthnot Banking Group. She criticizes the Bank of England’s failure to hike rates in November and fears they may have fallen behind. “They must start signaling that they are going to curb some of the craziest excesses in demand in order to tackle what could turn out to be built-in inflation,” she warns. “If inflationary expectations take hold, there is [Governor Andrew Bailey] may have to put [rates] in addition, and in the meantime, remember that fiscal policy is still fairly generous.

But what freedom does the Bank really have? Russ Mold, chief investment officer at AJ Bell, says he behaves like he has “more than one [US] Federal Reserve dual mandate, ”where unemployment is a common priority with inflation. “I suspect the Bank of England is also aware that the UK debt position is much higher than it was 18 months ago, so the economy is relatively more sensitive to minor variations interest rates, ”adds Mold.

What should investors and asset managers do? The mold is clear. “There is no alternative if you assume central banks will keep real rates negative for now. If you get a negative real return on bonds, a negative real return on cash… there is no alternative and you find yourself looking at stocks. “

There is a feeling that real assets will outperform paper assets in a truly inflationary episode

Mold favors actions that have pricing power over those that can be encouraged by competitors and customers. “You need companies with pricing power because otherwise your margins will be crushed,” he says. This is in contrast to the past decade, when investors invested in technology and growth stocks promising future profits.

“These are the same companies that you just don’t want to own in an inflationary environment because their costs are rising and they’re in a competitive fight for market share,” Mold warns.

It’s time to get cyclical

Instead, investors should support value stocks and cyclicals like banks, airlines and automakers, Mold says. He believes that we could see “a degree of violence within the stock markets and a change in market leadership”. And then there’s gold, which fared well in 1970s inflation, although he notes that it started from $ 35 an ounce at the time, rather than the level of $ 1,800 observed today.

“There is also the feeling that real assets will do better than paper assets in a genuinely inflationary episode, as central banks can print money but they cannot print gold, oil and gold. real estate, ”he said, adding that some investors would find a place for cryptocurrencies as a hedge.

Mold’s advice is echoed by Robert Sears, chief investment officer of private wealth manager CapGen, which manages £ 3 billion in assets. “There is no one-size-fits-all inflation hedge,” says Sears, who built CapGen’s hedge positions. “You want a number of different assets that perform well in different types of inflation. ”

In a low-growth inflationary environment, he recommends inflation-linked bonds, but if real rates rise, he supports commodities, liquid exposure to commodity futures and gold. For an environment “somewhere in between, where inflation is high but you still have relatively decent growth,” he turns to real estate, stocks with pricing power, and stocks of value.

Sears is particularly interested in inflation swaps today, primarily because they align with its assessment of the inflationary cycle. “Right now the focus is on inflation this year, next year… but what’s really interesting is that the markets are expecting inflation to come back pretty quickly in line with what is expected. ‘experience of the past 30 years. ”

However, he disagrees with this assessment, seeing a lot of potential risk of inflation over the medium term, in part due to lasting changes in Covid, such as relocation. Against this view, inflation swaps for the medium-term outlook appear undervalued in the market, he said. “There aren’t a lot of downsides, and yet if inflation was like it was in the 1970s, you’d be making a lot of money,” Sears says. As always, challenges present opportunities.



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