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Walking the inflation and interest rate tightrope

22 August 2022 Gareth Stokes

Central banks such as the Bank of England (BoE), South African Reserve Bank (SARB) and US Federal Reserve (Fed) are treading an inflation and interest rate tightrope as they attempt to rein in inflation without ruining post-pandemic economic growth. “The policy dilemma for central banks is controlling inflation without ruining economic growth; and that is an increasingly narrow path along which they walk,” said Richard Carlyle, Equity Investment Director at Capital Group, during his presentation to the 2022 PPS Retirement Summit. Capital Group, which is considered the world’s largest active equity manager with more than USD2.6 trillion in assets under management, has managed the PPS Global Equity Fund since 2019.

Caution and pessimism ‘pervasive’

Carlyle set out to describe the macroeconomic environment that asset managers and investors faced midway through 2022. His first observation was that a measure of caution and pessimism were not unexpected given the near 25% pull back on many global markets in recent months. “You do not often get stock markets falling by a quarter when the macroeconomic outlook is all positive,” he said. The main reasons for this pullback were described as rising geopolitical risk and uncertainty; slowing economic growth and the risk of recession; and, of course, surging developed market inflation. Capital Group is concerned that countries in Europe, and Germany in particular, could enter recessionary territory this year, in part due to the months-long Russia-Ukraine conflict. 

The outlook for the world’s second largest economy, China, is uncertain too. “China is struggling to cope with a property sector that seems perennially weak, and many of their property companies have very significant debt,” said Carlyle. “This is a worry for us”. Even so, the asset manager did not appear as concerned about this issue as other market commentators. This writer has, for example, seen speculation that China’s debt issues could explode, causing ripples through global financial markets similar in scale to 2008-9 Global Financial Crisis (GFC). The argument crystalises when one considers that the country’s property sector contributes around a quarter of its total GDP, and that mortgages account for a fifth of all outstanding loans! 

Out-of-control inflation

China aside, the main macroeconomic concern is that out-of-control inflation will force central banks to aggressively hike interest rates, introducing the possibility of stagflation. Stagflation, as FAnews readers will know, is an environment defined by high inflation and slow economic growth. The International Monetary Fund (IMF) is pencilling in an inflation rate of 9.5% for 2022, the highest in decades. And the United Kingdom and US are reporting inflation numbers at 40-year highs. 

Stock markets are a leading indicator of what to expect from interest rates. “The stock markets are pricing in Federal Funds Rates of 3.5% for the end of 2022, and the US has just been dealt a 0.75% rise to 2.25%,” said Carlyle. At the same time, the IMF has cut economic growth outlooks across the board. One of the main concerns raised during the conversation was that central banks were often behind the curve in responding to inflation. Using the Taylor Rule to illustrate this tendency, Carlyle showed that US interest rates should be nearer to 10% at present. “We have central banks misjudging the rise of inflation and looking to be behind the curve [insofar as responding to it], and that is not a great background for financial markets,” he said. “To summarise: there is a lot of uncertainty in the markets at the moment, making forecasting difficult”. 

How, for example, can asset managers price in the risk of Russia cutting off gas supply to the rest of Europe, or the likelihood of a recession in the US and continental Europe? The good news is that market leading asset managers are able to identify and invest in winning companies regardless of the macroeconomic outlook. 

Equities that will weather all storms

The first topic up for discussion under the ‘equity selection’ header was the well-publicised rotation out of growth and into value stocks. Although Capital One does not necessarily buy into this concept, it is one that it understands. “Value companies tend to be slower-growing, cheaper and dividend paying, [whereas] growth companies tend to be, as the name implies, rapidly growing and often not paying dividends at all,” explained Carlyle. An interesting observation is that the last time financial markets rotated from growth to value at such a rapid pace was around the time of the so-called Dotcom bubble burst in early 2000. 

Selecting stocks in current markets requires an understanding of various factors and their likely impact on individual company earnings and revenues. First up is inflation, which although high at present is likely to abate over the coming years thanks to the significant deflationary power of technology, among others. A second factor is interest rates, which are not as abnormally high as feared. “What we are witnessing is a move from extraordinarily low levels of interest rates back to normal interest rates; 2% to 3% is arguably low on a historical basis,” said Carlyle. He added that a prolonged period of low interest rates had been necessary for economies to recover from the GFC, and that normalisation was delayed by the 2020-21 COVID-19 pandemic. 

Looking forward to a ‘normalisation’ of markets

A third factor impacting equities is economic growth, which although slow at present will likely rekindle in coming years. According to Carlyle, he would prefer a ‘normalised’ market where more shares were performing in line with the underlying economy rather than a market where returns were driven by a handful of companies. This reality exhibited in the US equity markets leading up to and during pandemic, with the likes of Apple, Amazon, Facebook, Google, Microsoft and Netflix carrying the entire NASDAQ higher, while other shares languished. “We are looking forward to an environment where markets broaden out, and stock markets are not just about one or two companies doing well, and the rest of them badly,” he said. 

The PSG Global Equity Fund has responded to the value growth rotation by lightening its holdings of a number of technology firms and adding to its position in companies with industrial exposure. The fund’s largest addition over the past period has been Caterpillar; but it has also bought a railway, taken a position in an air conditioning firm, Carrier Global, and bought into Sika, a Swiss company that owns fascinating technologies that can potentially be used to recycle cement. The portfolio’s gradual shift towards value-focused industrial companies has been ongoing since 2020. Fund managers have also taken steps to insulate returns from the ravages of inflation. 

Know how to raise prices!

“In an inflationary environment, you need to find companies that have pricing power,” said Carlyle, pointing to one of the fund’s top 10 holdings, LVMH (Louis Vuitton Moët Hennessy). The main motivation for holding this share: “this is a company that knows how to raise prices”. Commenting on Caterpillar, he noted that the company was likely to be a major beneficiary of expenditure as companies and economies moved towards green infrastructure and renewable energy. In keeping with the retirement summit focus, Carlyle reminded attendees of the long-term nature of investment, saying that the fund manager’s New Perspective strategy had never failed to deliver a positive return over a rolling five-year period. 

Writer’s thoughts:
We love the metaphor of central banks “walking a tightrope” between inflation and interest rates and could not help but wonder whether the South African Reserve Bank (SARB) will have success in keeping our CPI within its 3% to 6% target. To do this, it will have to raise interest rates. Do you think the SARB will keep inflation under control; and how high can local interest rates go? Please comment below, interact with us on Twitter at @fanews_online or email us your thoughts editor@fanews.co.za.

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