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Investing in times of inflation

Long term investment strategies involve identifying investments that prioritise a quality focus to align with their financial objectives.

Long Term Investing during Inflation

The threat of inflation on long term investments

In long term investing and government, excluding individual spending policy decisions, inflation is the biggest threat to fiduciaries trying to preserve purchasing power. Numerous indicators signal challenges to stable global prices, compounded by societal groups influencing policies for short-term gains, reluctance to address critical issues promptly, and a political system favouring short-term benefits over long-term solutions.

This complex landscape portends an environment of higher inflation for a longer duration, which is likely to affect investments, and more importantly perhaps per capita real income, negatively thereby disadvantaging social justice.

In the 1980-2020 period of low inflation rates, and corporate returns on equity (RoE) exceeded prevailing interest rates. This was a bountiful period for stock investors, and there were times that even bond investments – secured at times of relatively higher rates – made money from declining interest rates.

During the declining interest cycle, unlike bond investors that could only reinvest at generally lower rates as bonds matured and investors renegotiated their contracts, equity investors benefitted from the reinvestment of retained corporate profits into whatever returns the company happened to be earning. Investors in companies had the benefit

achieved by companies, it’s been prudent to reinvest
Rising interest rates in response to higher inflation reduced the value of all existing fixed-interest investments. New corporate bond issues have increased
Now it’s

If business was able to base its prices on replacement costs, margins would widen in inflationary periods. But the simple fact is that most large businesses, despite a widespread belief in their market power, just don’t manage to pull it off. the source, peacetime inflation is a political problem, not an economic problem. Human behaviour, not monetary behaviour, is the key.
- Warren Buffett, Investor and CEO - Berkshire Hathaway

Long Term Investing During Inflation

What’s New? In the midst of evolving economic dynamics, we’ve maintained a cautious approach to both bond acquisitions and similar fixed-income-delivering assets (like real estate ventures). This strategy was rooted in a belief that the prevailing low inflation and interest rate environment that had characterised recent decades were unsustainable. And following the run-up in public-market equity valuations and private market equities our prudence extended even to equities.

Low rates and increased leverage drove short-term returns: It is our view that historically high market prices of equities in 2019-2022 were buoyed by low interest rates and exceptionally high Returns on Equity (RoE) – on leveraged assets. RoE experienced a remarkable surge between 2007 and 2022 globally, but particularly in the United States, where it was largely driven by increased leverage and share buy-backs.

These returns are even more impressive given that nominal returns from 2007 to 2021 were nearly on par with real returns. When adjusting for inflation, the high returns observed in 2022, which marked the peak of this timeframe, were significantly lower than historical averages.

Declining Profitability

One of the key drivers of our caution on equities were declining profitability. As interest rates rose, profitability, indicated by the spread between Return on Capital (RoC) and the cost of debt, experienced a decline. A continued period of lower profitability can be expected if the cost of debt (rates) stay high.

The S&P 500 index declined nearly 20% in 2022. And the year was not only unfavourable for most stocks, but also for most bonds.

A Family Office with a one-billion dollar investment portfolio would (at best) be shaken by a $200m paper loss, while a fully-invested portfolio of US$5 billion, would have seen paper losses close to $1 billion in 2022… enough to churn any stomach and increase the perceived need to exit equities and rush to “safety”.

How to consider the duration of Inflationary Impacts?

The low deposit rates offered by retail Banks, makes cash holdings unattractive, and government real government bond rates are still mostly negative (or only yielding marginally positively), which won’t change unless we see a major decline in inflation. Signals by the US Federal Reserve of a peak in inflationary expectations could be (at leat partially) undone by increased wage settlements, which feed through with a lag in the system (most often set in the first quarter of each year), and compound other more challenging inflationary pressures.

To assess whether we are exiting, or the possible duration of, an inflationary period, it is crucial to analyse the underlying causes of inflation. While cyclical recoveries post-COVID, and global supply chain constraints may have been the initial cause of an up-tick in inflation, the much larger monetary and fiscal drivers, and geopolitical reaction to Russia’s invasion of the Ukraine, at the same time as the liberalisation of gas pricing in Europe, were arguably much larger drivers. 

The cyclical may have passed, but structural challenges remain

The substantial growth in money supply, with the creation of 25% of all US dollars ever created occurring in the past few years, combined with fiscal stimulus, such as the US Federal Reserve’s $2.5 trillion private sector debt purchases at the highs, along with the cyclical recovery following the COVID-related economic shutdowns, and stimulus initiatives to fund a global energy transition, were significant contributors to the sharp increase in inflation.

Future inflationary risks presents itself in various factors, including ongoing growth in public and private sector credit, stimulative fiscal policies for potentially costly untested solutions within the energy transition, and attempts to structurally shift global trade flow back to traditional powers, that’s feeding through the global economy. These factors are exacerbated by the liberalisation of the European gas market and unprecedented geopolitical drive to energy security.

Industrial landscapes are being changed:

The shift in European hydrocarbon gas pricing, now based on the virtual Dutch TTF (Title Transfer Facility), the primary gas pricing hub for Europe, from previous long-term gas contracts, and the geopolitical response to the Russian invasion of South-Eastern Ukraine, which involved imposing purchase restrictions on Russian gas, oil, and petroleum products, have fundamentally altered the energy landscape.

With pricing driven by small flows, and larger players like Russia, Iran, and Venezuela effectively constrained in resolving energy prices, the risks of energy price inflation over the longer-term is elevated.

Energy inflation – influenced by more than merely demand and supply:

Countries that import energy and petroleum products, particularly emerging market economies in Africa and Asia, many of whom also import raw materials from Ukraine or Russia, have been significantly impacted by the prolonged regional conflict and the impact of retaliatory policies on energy costs. Many economies already burdened by COVID debt are further strained by the artificially high energy markets.

In light of the global condemnation of the Russian invasion, it is surprising that there’s not been stronger condemnation and reaction against specific OPEC countries that are advocating and implementing cuts in oil supply quotas. We are in effect condoning their opportunism during this tragedy.

A combination of higher imported inflation and increasing US dollar-denominated debt commitments (as a result of covid-related bailouts and higher energy costs) have led to a weakening of emerging market balance of payments and currencies, which in turn has pushed inflationary pressures even higher for them. Many of these countries have resorted to increased domestic currency lending to ease Balance of Payments pressures.

Real returns are greatly impacted by currency depreciations, and periods of high or hyperinflation can materially influence asset returns in Emerging Markets. This is a time to remain vigilant as the impetus to protect traditional geopolitical power structures increases.

The Implications of Rewiring the Globalist Economic system

The shift toward a more interconnected world after World War II, had roots in efforts to enhance economic efficiency, sharing resources, and fostering international collaboration. While anti-globalist sentiments may lean towards nationalism, the challenge lies in avoiding isolationist extremes and powerful alliances that seek to perpetuate global inequalities, which in the end could foster inter-national conflicts.

The trend of re-shoring production, which began under Barack Obama and gained momentum under Donald Trump with the implementation of tariff barriers, is expected to accelerate further due to the US Inflation Reduction Act stimulus and the European Green Deal Industrial Plan. While many are pointing at China’s fiscal stimulus as protectionist, the reality is the state sector in China is proportionately larger, and current stimulus are rather efforts to avoid deflation, and moreover to continue the uplifting of employment and incomes, which still massively trail US and European levels.

Structural changes to global trade and production flows, are likely to be associated with additional supply shocks with some relatively high degree of certainty over the medium term, leading to sustained inflationary pressures, which hold the risk of persistently high interest rates globally. Navigating this landscape requires nuanced strategies that acknowledge both the benefits of self-sufficiency and the importance of collaborative efforts to address global challenges.

Unfortunately, the momentum of populist movements leans towards simplified narratives driving for increased energy security, militarisation, protectionist trade policies, stricter immigration policies, and the strengthening of unilateralism of individual nations or international alliances. This inclination can contribute to a challenging and potentially turbulent path ahead.

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