Inflation is as much a political problem as an economic one
Huw Davies, Assistant Fund Manager, Fixed Income Alternatives, discusses the driving forces behind central bank policy action, as central banks appear to target lower inflation over stimulating growth.
Inflation is the key focus for major central banks, as the view of its ‘transitory’ nature falls out of the consensus to be replaced by an expectation that it will be a significant and long-lasting problem. Our reading of the situation is that inflation has become at least as much a political policy issue as it is an economic one and, for all that some central banks are nominally independent their governors are well aware which way the winds of political opinion are blowing. Faced with potential stagflation, it’s our view that central banks have chosen to target lower inflation over stimulating growth.
Most important for global fixed income markets, of course, is the approach taken by the US Federal Reserve (Fed), which now seems determined to return real rates (base interest rates minus core inflation) to positive territory. For that reason, the further six hikes in US rates – on top of the one already announced – that the Fed is currently guiding for seems plausible, and in any event our central thesis is that US interest rates will move significantly higher across the curve over the next 12-18 months.
Our team’s fixed income alternatives strategy is able to use a traditional range of fixed income exposures, but with the added dimension that we have the ability to go long or short in any of them at a given time. Within these broad parameters there are many ways that alpha could conceivably be generated, but at the moment we see the big call on the direction of rates as the key call investors need to get right. Our own approach has been to go short duration, given our views on the likely path of rates, although clearly that view is vulnerable to any major ‘risk-off’ move in equities that could spark a reach for yield. As a partial hedge against that we are also long USD, which we also like on fundamental grounds given the potentially unbalanced mix of growth across the world over the remainder of this year.
Finally, commodity prices have undoubtedly been strong and in our estimation the world has moved into a macro environment where the security of commodity supply lines, as much as the price of those commodities, is a primary focus for governments around the world. So the currencies of any country that is primarily a commodity exporter – for example Australia or Indonesia – looks to us like offering attractive diversification potential.
What higher energy costs may mean for UK equities
Tim Service, Fund Manager, UK Small & Mid Cap, discusses the potential implications of higher energy prices on companies, consumers and investors in the UK.
The high cost of energy is making headlines in the UK – but what are the investment implications? Oil producers are the obvious beneficiaries of rising oil prices. However, as UK small and mid cap investors, the listed oil stocks in our part of the market tend to be specialist producers and explorers, often exposed to just one or two oilfields. This area of the market has a chequered history, even in times of rising oil prices. They tend to have challenging assets with high operating costs, require a lot of capital, and are prone to unforeseen mishaps. While the share prices rally from time to time, it has been an easy area to lose a lot of money over the last few decades in the UK. We’re wary of buying into businesses like this, particularly given the elevated ESG risk on some of these businesses as well. So in our view there a lot of reasons not to own these stocks.
There are also a number of industrial companies that serve the energy sector, and these can potentially benefit if we move into a scenario of sustained demand for higher oil and gas production. In most cases, exploration and development budgets would need to increase to drive their sales, and after a long bear market in energy prices, it would probably require a sustained period of higher prices before that happens.
Obviously, there are many losers from a higher cost of energy. Airlines are obviously facing higher fuel costs, but sometimes a short-term crisis can bring longer term opportunity: for example, the combination of higher oil prices and the disruption to travel from Covid lockdowns means that the strongest businesses will likely take market share.
But perhaps the most important consideration for higher energy prices is the impact on consumer spending. Over the last couple of years where there have been tailwinds for many consumers – banked furlough checks and fewer opportunities to spend money during lockdowns allowed savings rates to rise. But we’ve now got headwinds in the form of increased gas and electricity costs, and higher prices at the petrol pump, and these things matter.
In our team we spend a lot of time looking at household cashflow forecasts to get a feel for what is left over for consumers to spend on discretionary items, as this feeds into demand for UK domestic-focused companies. In a squeezed environment, businesses with pricing power or that are doing something relatively unique with high profit margins should be best placed, and it is at those sorts of companies that our investment style naturally gravitates towards.
In essence, whenever there are big shocks – like rising oil prices – equity markets tend to over-react in some areas and under-react in others and that can create opportunities for active stock-pickers.
The value of active minds: independent thinking
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