Inflation is the key culprit
The most significant market move over the last few weeks was the rise in US bond yields that reflected the possibility of the US Fed not being in control of inflation, which reached 5.3% in September 2021, a level not seen since 2008. The latest figure was released on 12 January 2022 at 7.0% (5.5% excluding food & energy), a level last seen in the 1980’s.
As such, US bond yields have risen in anticipation that the US Fed will have to raise interest rates by around 1% over the course of 2022 to bring these inflation levels back down.
High inflation and rising interest rates are a bad combination for bond holders as well as some companies, notably those expected to grow substantially, but in the future and whose current levels of profitability may be low relative to elevated valuations (so called high growth companies). Meanwhile, this can be a good combination for hitherto out of favour companies that are very cheap and have the potential for strong earnings growth such as energy, mining, and financial companies.
In recognition of this risk, we had already reduced our exposure to the more expensive end of the market over the course of 2021. The questions we are now asking are i) whether our thesis of transitory inflation is still valid and ii) whether the rise in market interest rates is sufficient or whether there is more to come.
So, is it transitory or not?
From our analysis, inflation in the US is currently so high mainly due to the price of cars which have risen over 20% in the last year. We believe it’s unlikely that car prices will grow at this pace forever – it’s more usual for cars to depreciate. Excluding this component would see US inflation running closer to 3%, which is still higher than pre-pandemic, but not alarmingly so.
Recently, the cost of labour in the US has risen markedly given the acute shortage of workers. Aside from health concerns, many people over 55 years old have decided to retire early. This is causing companies to offer higher wages to fill vacancies and has the potential to sustain higher inflation across a broader spectrum of components.
There has been a sharp shift away from the idea that inflation will be transitory, based on the labour market tightness. Hence, we have seen a shift away from the idea that interest rates will remain low. Expectations are now for rates to gradually rise over the coming year.
Looking at inflation expectations and expected rate hikes by the markets, for now, most of the adjustment has been made. The risk, of course, is that wage increases continue, inflation pressures continue to build and this rise in interest rates turns out to be insufficient.
What are we doing in portfolios?
In recognition of this risk, we had been reducing our exposure to the more expensive end of the market for much of the course of 2021.
In our defensive holdings, we had already chosen to bias towards shorter dated bonds (asset backed securities in particular) and inflation linked bonds, each of which outperformed.
Over the next few weeks, we will get more data on economic activity, jobs, wages and the US Fed will make its interest decision. As this data comes in, it will create a clearer picture of which direction the growth/ inflation/ interest mix is heading. This will lead us to either increase allocations to the strategies mentioned above or use it as a buying opportunity for beaten up growth companies operating in areas where we see the best long term, structural, thematic growth trends – such as technology, healthcare, and environmental solutions.
