Milton Friedman once said, “Inflation is the one form of taxation that can be imposed without legislation” and that seems an apt way to start this quarterly commentary.

Inflation around the world has been gradually accelerating throughout the year. This is because demand is surging as restrictions are eased but also because of various supply side issues. As we know, when demand outstrips supply, then prices go up.

UK Consumer Price Inflation is now 3% and expected to move higher through the rest of 2021. The inflation figure released in September was also the biggest monthly increase recorded since records began in January 2006.

UK Consumer Price Inflation (%)

Source: Office for National Statistics (August 2011 to August 2021)

This seems to be more obvious in the UK now because of the driver shortages which has led to irrational panic buying (again) this time of petrol – which is pushing prices higher. It can also be seen by looking at the price for natural gas which has rocketed and leading to several energy providers to fail. Another sign of higher inflation is that wages also seem to be rising in certain sectors.

The key consideration for Luna is how do we position portfolios in this environment. The good news is we have been thinking about this for some time and were making changes at the end of 2020 in the expectation for this type of environment. The most at-risk area from inflation is cash because interest rates are basically 0%. As you can see from the below chart, over the last 10 years, inflation, this time Retail Price Inflation, has been significantly higher than the returns delivered from holding cash. This means that investors have lost out in real terms from holding cash. Back to Milton Friedman and that is a tax to holding cash. Looking forward this is a tax that is currently 3% and rising.

UK Retail Price Inflation vs Cash (LIBOR) (%)

Source: Morningstar Direct 01/09/2011 to 31/08/2021)

The next asset class that is vulnerable to higher inflation levels is bonds and fixed income assets. Again, these assets have very low yields – which makes them not overly attractive investments in a higher inflation world. It should therefore be no surprise that we are underweight these areas in portfolios.

On the flip side, there are also opportunities to make money from higher levels of inflation by looking for real assets and targeting specific companies that can pass on higher levels of inflation without having their margins squeezed from higher prices. Additionally, we have been refocussing on the companies we invest in to ensure that they can endure this environment.

Away from inflation, there have also been some big developments going on in the Far East and specifically in China. The Chinese authorities have decided that they did not want the education sector to be profitable because it was stopping individuals having more children. This political intervention knocked investor confidence. The authorities then targeted the big Technology companies and their profitability – again

knocking confidence from investing in the region. Finally, there have been concerns from investors around Chinese property, specifically focussed at Evergrande Group. This again shook confidence in the region and share prices were weak again.

It’s not all been bad news for the Far East during the quarter though, the best performing region has actually been Japan and the Nikkei 225 which increased by 5%*.  The Japanese stock market has performed strongly on the back of the Olympics and following Prime Minister Yoshihide Suga’s abrupt departure. Suga’s one-year tenure as prime minister was marred by an unpopular COVID-19 response and dwindling public support.

Equity Market Performance – Q3-2021 (%)

The next asset class that is vulnerable to higher inflation levels is bonds and fixed income assets. Again, these assets have very low yields – which makes them not overly attractive investments in a higher inflation world. It should therefore be no surprise that we are underweight these areas in portfolios.

On the flip side, there are also opportunities to make money from higher levels of inflation by looking for real assets and targeting specific companies that can pass on higher levels of inflation without having their margins squeezed from higher prices. Additionally, we have been refocussing on the companies we invest in to ensure that they can endure this environment.

Away from inflation, there have also been some big developments going on in the Far East and specifically in China. The Chinese authorities have decided that they did not want the education sector to be profitable because it was stopping individuals having more children. This political intervention knocked investor confidence. The authorities then targeted the big Technology companies and their profitability – again knocking confidence from investing in the region. Finally, there have been concerns from investors around Chinese property, specifically focussed at Evergrande Group. This again shook confidence in the region and share prices were weak again.

It’s not all been bad news for the Far East during the quarter though, the best performing region has actually been Japan and the Nikkei 225 which increased by 5%*.  The Japanese stock market has performed strongly on the back of the Olympics and following Prime Minister Yoshihide Suga’s abrupt departure. Suga’s one-year tenure as prime minister was marred by an unpopular COVID-19 response and dwindling public support.

Equity Market Performance – Q3-2021 (%)

*Source: Morningstar Direct (30/06/2021 to 30/09/2021)

In summary, the headlines are full of signs of higher inflationary pressures and volatility in markets has picked up after a very strong 18 month rebound from the Covid lows in early 2020. At Luna we feel well placed to navigate this environment and the changes we made in 2020 have held us in good stead.  We continue not to get swept in the short-term headlines but focus on making good investment decisions for the longer term.

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