Brace for higher inflation

Interest rate rises to quicken rotation from growth to value stocks.

John Whelan and Kevin Bertoli, PM Capital

Over the past year, PM Capital has suggested that a rotation from growth to value was on the horizon, and any rotation could take up to a decade or longer to fully play out. 

Consistent with these views, we actively positioned our portfolios to benefit from this transition. We reduced exposure to growth stocks, such as those in the technology and payments sectors - areas which had been cornerstones of the portfolio for a better part of a decade. This capital was redeployed to increase our weightings in global banks and commodity producers, which we viewed as well placed to outperform. Also, we increased our short position over the NASDAQ, a key barometer of global tech stocks.

Two factors shaped our view. 

First, many value segments of the market traded at record-low relative valuations. Conversely, growth stocks continue to make new highs and valuations screened as expensive. The case for value stocks was compelling. 

Second, we expected inflation was likely to be more persistent than consensus initially anticipated, which would flow through to rising bond yields in 2022. We disputed the view that the spike in inflation was temporary and solely due to Covid-induced supply-chain bottlenecks. 

These two factors were intertwined. A recognition that inflation was more than temporary would force central banks to lift rates sooner, and more aggressively, than the market expected. In turn, expectations for rate increases would accelerate the rotation from growth as investors re-evaluated valuations and growth assumptions.

A 40-year interest rate cycle, where rates fell to zero, has fundamentally changed investor behaviour. Although ultra-low interest rates have been a tailwind for most asset classes, none have benefited more than long-duration growth stocks. When rates are low, future growth is worth more when discounted back to present value. Cheap debt also helps capital-hungry growth companies and encourages speculation. 

Combine this with the impact the pandemic has had in pulling forward demand for many growth companies, and you had a utopian environment for growth stocks. This dynamic was highlighted succinctly by Morningstar data, which showed that for the rolling 10-year period ended December 2020, large value underperformed growth by its widest margin since 1999.1   

PM Capital’s favoured sectors - global banks and commodity producers- were both well placed to benefit in this environment. Commodities are central to the inflationary story playing out in the economy while bank earnings will benefit initially from rising interest rates. 

Rotation quickens

This thesis is broadly playing out as PM Capital expected. The NASDAQ Index has fallen almost 16% from its November 2021 high2 and is approaching bear-market territory.3

Inflation has become the market’s top concern. In December 2021, the US Consumer Price Index rose 7% from a year earlier – the fastest pace in almost 40 years.4

In late January 2022, the US Federal Reserve signalled it will start raising rates in March and that it will consider reducing its balance sheet. Inflation is forcing its hand to lift rates.

The Fed’s official statementsaid: “With inflation well above 2% and a strong labour market, the committee expects it will soon be appropriate to raise the target range for the federal funds rate.”

In Australia, inflation news sparked an equity market sell-off in January. Headline inflation spiked to 3.5% in the year to end-December 20216, trouncing market expectations. It was the fastest annual pace of growth in eight years.

The market believes surging inflation will force the Reserve Bank to pivot from its view that the first interest-rate rise will not be until mid-2023 onwards.7 In early February 2022, the Reserve Bank kept interest rates on hold, but RBA Governor Philip Lowe conceded a rate rise was possible this year, depending on the economy’s strength8.

Clearly, inflation is rising faster than first thought. The debate over temporary or permanently higher inflation has shifted. Higher inflation is here to stay and yet again, central banks worldwide look to be ‘behind the curve’ on the timing of rate rises. 

Inflation concerns

While many market commentators pay attention to headline or core inflation numbers, PM Capital delves deeper on inflation. We look for signs of price pressures across a range of cost inputs, in Australia and overseas. Our goal is to identify and understand input price pressures that will eventually translate into higher output prices.

Of course, there are transitory factors driving some near-term inflationary inputs. We just need to look at the impact that chip shortages have had on used car prices in US as one obvious example. Over time, we agree these transitory factors will normalise.

However, we also see areas of inflation that we consider to be more structural in nature, such as labour costs and energy. Given labour and energy are two of the most important inputs of most goods and services, our assessment of future inflation has troubling flow-on effects. 

Starting with labour, in the US in November 2021, a record 4.5 million workers – or 3% of the US workforce – quit their job.9 For every 100 job openings in October 2021, there were only 69 unemployed workers.10 In 2019, there were 84 unemployed workers for every 100 job openings. US labour supply is shrinking.

In late December 2021, The Washington Post11 reported that the pool of potential workers in the US has shrunk so much that it will be hard to get back to pre-pandemic employment levels. An unemployment rate of 2% will be required, which is lower than at any point since US employment began to be measured in 1948.

When labour demand outstrips supply, wage costs rise. A record 48% of US small-business owners said they raised wage compensation in December 2021.12 Rising wages force more companies to lift prices, to maintain profit margins.

Now consider energy and the push to transition the global economy from fossil fuels to renewables. While transiting the global economy to more renewable sources of energy may be a long-term prerequisite, doing so is proving to be a complex and costly process to get right. It is no coincidence that electricity prices tend to be highest in places with the greatest share of renewable solar and wind generation.13

Adding to the pressure on energy prices has been the decision by several developed economies, particularly in Europe, to phase-out of nuclear power despite it emitting relatively low greenhouse emissions over its lifecycle. 

The impact is most notable in Germany, where the government passed legislation in 2011 to phase out nuclear within 10 years. At the time this legislation was passed, nuclear contributed more than a quarter of the country’s power output. This has since fallen to 13% and is planned to fall to zero by 2023.14 The side effect of this decision is a growing reliance on imported natural gas and in turn rising electricity prices.

The war against emissions has also resulted in a backlash from governments and investors towards the oil and gas sector, which has seen companies divert capital expenditure. Consequently, oil and gas discoveries in 2021 were likely to hit their lowest level in 75 years.15 That means less supply of oil and gas despite demand continuing to grow at least in the medium term. The likely result: another source of higher energy prices.

Higher energy prices are now flowing through to food production. Europe’s gas crisis is already hitting food prices. The Netherlands, the world’s second-largest food exporter, is grappling with soaring gas and electricity prices. Energy accounts for up to 30% of the cost for most glasshouse crops.16 Nitrogen fertilizers, the most used fertilizers in global food production and one where gas is the primary feedstock, have also doubled over the past year.17

What this means for investors

The market is belatedly recognising the inflation problem but continues to underestimate its magnitude. Central banks worldwide are changing their rhetoric and we believe they will be forced to lift rates sooner and faster than they outlined last year.

This inflection in inflation and interest rates – decades in the making – will do three things. First, market volatility will be higher in 2022. This will create opportunities for value-focused investors, such as PM Capital, during market corrections.

Second, equity returns will be constrained. Investors should expect a more moderate return as global markets adjust to rising inflation and interest rates. 

Third, loss of purchasing power will become the key investment risk this decade. If inflation rises as PM Capital expects, consumer purchasing power will erode. Those living on fixed incomes could be hurt by rising food, energy and healthcare costs.

Holding a diversified portfolio of equities, bonds, cash, and alternatives will be less effective. Investors will need larger allocations to equities and cash in their portfolios. Well-chosen equities can deliver higher real returns (after inflation). Cash provides the optionality to buy more equities when markets correct. 

Nobody knows for sure how inflation, rates and markets will play out this year. We do know that what worked well in the previous decade – when inflation and rates were low – will not work as well this decade. Higher inflation and rates change everything.

PM Capital is well-positioned for this phase of the economic and market cycle. We expected higher inflation and rates – and a correction in growth stocks – and that is the case so far. Our portfolio comprises companies we believe should outperform as inflation rises. 

2022 will be a tough year. Major market inflection points are difficult times to invest in. But they are also periods when foundations for attractive future returns are laid. 

As a disciplined value investor, PM Capital patiently waits for market turning points. That’s where we are now, but this story has a long way to run.

 

-    John Whelan and Kevin Bertoli are Portfolio Managers at PM Capital.
 

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Notes and References

1. https://www.morningstar.com/articles/1017342/value-vs-growth-widest-per…;
2. The NASDAQ 100 was 16,057 points on 19 November 2021. It closed at 13,359 points on 26 January 2022. 
3. A fall of at least 20% from the high.
4.US Bureau of Labour Statistics. “Consumer Price Index Summary.” 12 January 2022.
5. US Federal Reserve. “Federal Reserve Issues FOMC Statement.” 26 January 2022. https://www.federalreserve.gov/newsevents/pressreleases/monetary2022012…   
6. Australian Bureau of Statistics 
7. Reuters. “Australia’s Central Bank Opens Door to earlier rate rise, pledges patience.” 2 November 2021. https://www.reuters.com/business/australias-central-bank-holds-rates-dr…  
8. Based on comments for RBA Governor Philip Lowe at National Press Club luncheon in Sydney on 2 February 2022.
9. US Bureau of Labour Statistics. Economic News Release. 4 January 2022
10. US Bureau of Labour Statistics. Job Openings and Labour Turnover Summary. 4 January 2022
11. Flowers, A., Van Dam, A. “The Most Unusual Job Market in Modern American History Explained.” The Washington Post. 29 December 2021. https://www.washingtonpost.com/business/2021/12/29/job-market-2021/
12. Bloomberg. 6 January 2022
13. https://foreignpolicy.com/2021/10/08/energy-crisis-nuclear-natural-gas-…
14. World Nuclear Association. ‘Nuclear Power in Germany’. January 2022. https://world-nuclear.org/information-library/country-profiles/countrie…
15. Rystad Energy. As reported by Snyder, J. in Riviera. “Rigs Report. Oil and Gas Discoveries at Lowest Levels in 75 Years.” https://www.rivieramm.com/news-content-hub/news-content-hub/rigs-report…
16. Bloomberg October 2021. https://www.bloombergquint.com/onweb/your-tomatoes-may-cost-more-as-gas…;
17. https://www.spglobal.com/platts/en/market-insights/blogs/agriculture/01…