Inflation levels globally have been creeping higher in 2021. In the UK, Consumer Price Inflation (CPI) is now 2.5% above the Bank of England 2% target, whilst Retail Price Inflation (RPI), which includes mortgage interest payments, is at 3.9%.

The Bank of England also said recently that they expect inflation to continue to move higher over the coming months with CPI increasing to around 4%. 

Inflation is important for investors to keep abreast of because it has a significant impact on the real value of individuals wealth – the higher the level of inflation then the greater the risk of capital in low yielding assets being eroded over time. In this Luna Perspective, we will examine the root causes for this increase in inflation levels, explain how central banks are viewing this and how we have positioned portfolios to protect and benefit.

 Why is inflation on the up?

Global economies are gradually reopening from Covid induced restrictions and demand is surging. This is at a time when the supply of some goods is tight because of issues with global supply chains, some of this driven by Covid and also by the blockage at the Suez Canal. With demand outstripping supply then the prices of raw materials and goods are moving higher. The excess level of demand is also more obvious in other sectors, for example, in the travel and hospitality sector, where we have been unable to travel or go to restaurants for circa 18 months and have flocked back as price-insensitive buyers. This enables firms to keep prices higher.

What are Central Banks doing?

The short answer is ‘not a lot’ but they are monitoring the situation. Central Bankers don’t seem to be overly concerned about inflation currently and see this as a short-term increase as economies rebound. The term being used to explain this increase in inflation is “transitory”. This is because central banks are more worried about cutting off economic growth as their economies emerge from the Covid induced recession that has been with us over the last 18 months. Therefore, don’t expect to see interest rates moving higher any time soon to combat the current trend of higher inflation.

 One recent development from Central Banks which has been interesting is the fact that their language to higher inflation seems to have changed. The Federal Reserve and European Central Bank (ECB) have moved to talking about “average inflation targeting” i.e. if inflation runs below trend for a period of time then it will be allowed to run above trend for an equal period of time – so that the average over the period is in line with their target. Historically, central bankers became more concerned when inflation moved above their target, typically at 2%. This is the first time central banks language to inflation has changed for many years. 

 What has been the market reaction?

In early 2021 government bond prices were extremely weak and this led to bond yields moving higher. This was because the expectation was that inflation would be moving higher throughout the year. More recently, this trend has reversed when higher inflation figures have been coming through. Importantly, in asset markets there are often a number of driving factors behind price movements – at the moment the dominant factor isn’t inflation but investors are more cautious because of the spread of Covid-19 variants and potential restrictions that come in future months.

What has been the market reaction?

In early 2021 government bond prices were extremely weak and this led to bond yields moving higher. This was because the expectation was that inflation would be moving higher throughout the year. More recently, this trend has reversed when higher inflation figures have been coming through. Importantly, in asset markets there are often a number of driving factors behind price movements – at the moment the dominant factor isn’t inflation but investors are more cautious because of the spread of Covid-19 variants and potential restrictions that come in future months.

 

The government bond market moves in 2021 have had spillover impacts into other asset classes, like equity markets as well. More growth orientated companies can sometimes be priced off a discount rate, which is linked to government bonds. Investors look to discount future cash flows to a value today. As bond yields increase, so do discount rates which means the present value of these businesses is smaller i.e. the value of the company is less and their share prices fall.

What is Luna doing?

We currently have a low allocation to areas that we see as vulnerable to higher inflation; cash/money market instruments and traditional fixed income markets e.g. government and corporate bonds. This is because the current level of inflation is higher than the interest that can be earned from buying and holding these assets.

This means your purchasing power and the value of your wealth is gradually being eroded over time. When investing in these assets for a long period, the compounding impact can be extremely detrimental to your wealth. 

As highlighted by the graph below – over the last ten years. If investing £100k then adjusting for Retail Price Inflation would now leave you with £129,251, whereas investing in cash (LIBOR) has only increased to £105,899. That’s a staggering £23,352 difference. This was at a time when inflation hasn’t been roaring ahead in the UK but crucially the reason for this difference is because interest rates have been rooted to lows since the Global Financial Crisis. Looking forward this gap looks likely to widen further with inflation at 3.5% and the Bank of England base rate now even lower at a 327 year low of 0.1%.

Source: Morningstar Direct (01/07/2011 to 30/06/2021)

Source: Morningstar Direct (01/07/2011 to 30/06/2021)

Are all assets vulnerable to higher inflation?

No. There are ways to benefit from this environment. For example, “real assets” tend to do well against this backdrop as the real value of the asset increases with higher levels of inflation. When we talk about real assets then think of; property, commodities and to a certain extent equities. 

Certain companies with pricing power can pass on higher price levels to their consumers – and offset the impact of higher raw material costs. 

At Luna, we have a bias for quality businesses – focusing on companies with earnings growth, high margins and in doing so looking for a business that can deliver returns in excess of inflation. 

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