Long Term Investing during Inflation

What's New? We have exercised caution regarding bond purchases and even real estate acquisitions, in context of the prevailing low inflation and interest rate environment of recent years. We were cautious even on equities.

Low rates and leverage drove short-term returns: It's our view that the historically high market prices of equities were buoyed by the low interest rates and exceptional Returns on Equity (RoE). RoE experienced a remarkable surge between 2007 and 2022 globally, but particularly in the United States, 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.

Profitability declining? As interest rates rose, profitability, indicated by the spread between Return on Capital (RoC) and the cost of debt, experienced a decline. A tougher market can be expected if rates stay high.

In return, the S&P 500 index saw a substantial decline of nearly -20% in 2022. And last year was not only unfavourable for most stocks, but also for bonds.

A Family Office with a one-billion dollar investment portfolio would (at best) be shaken by a $200m paper loss, a fully-invested US$5 billion portfolio close to $1bn... enough to churn the stomach and increase the perceived need for safety.

But, the low deposit rates offered by Banks, makes cash holdings unattractive, and government bond rates are still mostly negative.

Cause of Inflation: While inflationary pressures are a well-known characteristic of the market, it is crucial to analyze the underlying causes of inflation.

Inflation can arise from various factors, including excessive growth in money supply, fiscal policies, and structural shifts in the economy.

The first two causes have been thoroughly analyzed.

The substantial growth in money supply, with 25% of all US dollars ever created occurring in the past two 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, were significant contributors to the sharp increase in inflation.

However, these factors were exacerbated by the liberalisation of the European gas market and geopolitical shifts.

Energy pricing has 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, as opposed to 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 industrial landscape.

Main losers: 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 ensuing retaliatory policies.

A combination of higher imported inflation and increasing US dollar-denominated debt commitments has led to a weakening of emerging market currencies.

Real returns across countries are greatly impacted by currency depreciations, and periods of high or hyperinflation

Real Annualized Returns (%) on Equities versus Bonds and Bills Internationally, 1900–2015

Additionally, OPEC, led by Saudi Arabia, a long-time consumer of US arms and military technology, has aggressively reduced crude oil supplies without meaningful resistance from alliance partners.

Many economies already burdened by debt due to COVID stimulus policies are further strained by the artificially high energy markets imposed by allies.

Lower Costs? Furthermore, the trend of re-shoring production, which began under Barack Obama and gained momentum under Trump with the implementation of tariff barriers, is expected to accelerate even further under Biden due to the US Inflation Reduction Act.

Similar measures, such as the CBAM (Carbon Border Adjustment Mechanism), and fiscal stimulus policies in Europe, are also impacting overall costs.

The inflationary pressures have spilled over into the services sector, and combined with lagging salary increases and structural changes in the fuel industry, they are anticipated to result in persistently high interest rates and potentially even further rate increases.

Are bonds Back? Some investors are already anticipating a declining rates cycle. They believe peak inflation has passed.

That might be a good trading opportunity, but over the longer-term, bonds are expected to structurally underperform a portfolio of companies earning Returns on Capital in line with (or above) long-term average industry returns.

Asset Performance and Industry Weightings in the USA and UK, 1900 Compared with 2015

Railroads, textiles, iron, coal, and steel all declined precipitously.

In turn, the pace of change has accelerated. Companies (and countries) have to deal with more information, with quicker technological change, leading to unpredictable outcomes. Requiring more skills, more qualified people!

"Whether these changes are are for good or for ill must be our choice. Technology itself is neutral." - Charles Handy - The Age of Unreason (1990)

Unlike the railway companies of old, to sustain performance, great companies need growth without the need for high, or additional, invested capital. Companies that can show the best growth with the lowest capex and financing needs.

Science of Hitting: In an email response to Jeff Raikes, then with Microsoft, Warren Buffett describes Ted Williams's drawing of a batters box, with lots of little squares in it, all part of the strike zone... as outlined in his book called the Science of Hitting.

In his favourite spot, the little square showed .400, reflecting what Williams thought he would hit if he only swung at pitches in those area, in his happy zone.

Buffett believed that he was not capable of assessing probabilities in favour of a 20-year run in Microsoft, in this technology, in this now famous analogy.

Great companies, that can sustain growth for the next 20, even 30 years, are not easily found, but when you do, your chances of successful investment improves dramatically (they are like fat pitches).

The next steps?

The history shows that over the long run, there was a reward for investing in stocks. Foreign exchange fluctuations are (over the long-term) mostly responding to relative inflation, and the impact of exchange rate fluctuations on investment returns has been relatively modest.

We advise to carefully evaluate the profile of fixed-income and emerging markets investments during inflationary times and explore alternative strategies to mitigate potential losses.

This article isn't personal advice or a recommendation to invest. All investments and any income they produce can fall as well as raise in value, so you could get back less than you invest. If you're not sure an investment is right for you, ask for financial advice.

Phone: +44 (0)79 1751 7859

Email: opinions@littlesquarecapital.com

Website: www.littlesquarecapital.com

To subscribe to our newsletter email click here