Inflation or deflation

With lockdown restrictions having caused sharp drops in demand and rising unemployment, the impact of COVID-19 has been disinflationary. The UK and US have registered the lowest levels of inflation since 2016 and 2015 respectively. Is this set to continue, or will government stimulus measures lead to more significant inflation over the longer term? The Association of Investment Companies (AIC) has spoken to investment company managers about how they’re viewing the prospects for inflation and how their portfolios are positioned.


Charles Luke, Manager of Murray Income Trust, said: “The pandemic will impact the UK and global economy in a myriad of areas, but higher inflation is unlikely. In fact, just like in the aftermath of the global financial crisis the risk is more of a disinflationary threat. Any pockets of price pressures that may have built up from supply constraints will be more than offset by weak demand. Rising unemployment and the likely staggered recovery in consumption will weigh heavily on the outlook for wage and price growth. Fiscal and monetary policy stimulus should help cap some of these disinflationary forces, but are unlikely to fuel inflationary pressures over the next two years.”

Peter Spiller, Manager of Capital Gearing Trust, said: “Any demand shock is in the short term deflationary, and in this regard COVID-19 is no different. How the balance of supply and demand evolve over the coming months and years is more complex and harder to predict. Marginal capacity will be mothballed and investment in new capacity put off but all this will take time. The desired savings rate for both consumers and corporates will rise: a natural psychological reaction to these tumultuous events. Governments have already stepped in to attempt to fill this demand gap via various stimulus measures, furlough schemes and so forth. Further fiscal stimulus remains likely though its exact form – whether student debt forgiveness, a green new deal, or helicopter money – is not clear. Globalisation of trade, the single greatest factor in keeping inflation in check over the last 20 years, has come to a halt and may yet go into reverse: driven partly by a souring relationship between China and the US and partly by the newly apparent fragility of ‘just-in-time’ globalised supply chains.”

Hamish Baillie, Fund Manager of Ruffer Investment Company, said: “The debt-financed promises from governments to protect jobs and the economy require negative real interest rates in order to be affordable. This will result in bond yields being nailed to the floor and a relatively laissez-faire approach being taken to inflation running above target. In addition to the benefits and necessity for government finances, this is also politically palatable as it acts as a transfer of wealth from savers (the elderly and well-off), to borrowers (the younger and indebted generations).”

“At a company level, supply chains and balance sheets are going to change from an ‘optimised’ just-in-time model to a just-in-case model. This will result in closer control of supply chains, greater inventory and some rainy-day reserves being held on balance sheets. All things being equal this will reduce profitability and so prices will rise to match this – the costs of those places in a half empty aeroplane, restaurant or hotel are going to be more expensive not cheaper.”

Walter Price, Portfolio Manager of Allianz Technology, said: “We expect inflation to stay low for the next year with a 20% unemployment rate and workers that have to find new jobs to replace those in many areas that aren’t coming back soon.”

Simon Edelsten, Fund Manager of Mid Wynd International Investment Trust, said: “Our priority in managing Mid Wynd is to achieve real returns to investors over the long term and we are well aware that the greatest threat comes from periods of unexpected economic turbulence.  The current pandemic and governments’ lockdown measures have led to a sharp decline in economic activity and higher unemployment though these may moderate as lockdown measures end. These factors tend to be sharply deflationary.  However, we have also seen announced very large stimulus measures around the world and this expansion can concern investors and tend to be inflationary and may make some currencies weaken.”

“The need for inflation”

Peter Spiller, Manager of Capital Gearing Trust, said: “Most important of all is the need for inflation. Once the crisis abates public debt will be at levels not seen since the Second World War. The solution to such problems will be the same now as then: financial repression, a prolonged period of low interest rates and elevated inflation. The tools available to governments and central banks are the same as then, we cannot see the outcome being any different.”

Portfolio positioning

Simon Edelsten, Fund Manager of Mid Wynd International Investment Trust, said: “Mid Wynd invests in companies which have very strong market positions and which, therefore, tend to be able to raise prices when there is modest inflation or deflation – for instance Thermo Fisher, the world leader in scientific equipment, faces little price competition, rather competes on quality of product. Indeed a long period of deflation, such as has been seen by global investors in Japan over the last twenty years, tends to favour growth stocks with world leading technology over other investments. Very high inflation, perhaps triggered by excess public spending, is a challenge for equity and bond investors so we have a modest allocation to gold mines in the fund which should offset part of this risk to capital value if it arises – we do not expect it to happen, but we are prepared just in case.”

Charles Luke, Manager of Murray Income Trust, said: “The portfolio is not driven by top down themes. However, on the basis of our assessment of fundamentals the portfolio has limited exposure to banks which would tend to benefit from an environment of higher interest rates and a more meaningful exposure to pharmaceuticals and consumer goods companies, such as AstraZeneca and Diageo which should benefit from a relatively low inflation environment.”

Peter Spiller, Manager of Capital Gearing Trust, said: “Low interest rates and elevated inflation means strongly negative real interest rates. The best performing asset class in this environment is likely to be index linked bonds. We favour US TIPS but also hold index-linked bonds in Japan, Sweden and Australia. Gold could do well too, though of course it is rather harder to value. In such an environment any cashflow that is reasonably secure with good inflation correlation should become more highly valued by the market. To that end we have been buying property, particularly with long leases and good covenants.”

Hamish Baillie, Fund Manager of Ruffer Investment Company, said: “What don’t we own? Conventional bonds, cash other than for short-term tactical reasons and a large exposure to equities. What do we own? Government backed inflation-linked bonds in the UK and US, gold and a low weighting to equities.”

Longer term - globalisation “more important” than technology

Peter Spiller, Manager of Capital Gearing Trust, said: “Since the onset of COVID-19 the impact of monetary policy has largely been to inflate the value of asset prices rather than prices in the real economy. We expect this to change as prolonged low interest rates are combined with expansionary fiscal policy over an extended period of time. Technological developments have and always will be deflationary. However, the pace of technological change today is no greater than average over the past 200 years and possibly rather slower. Of greater significance in recent times has been the impact of globalisation and the entry of previously untapped labour pools into global markets. As the tide of globalisation turns and perhaps starts to ebb, this trend should reverse.”

Hamish Baillie, Fund Manager of Ruffer Investment Company, said: “At a geopolitical level, globalisation is in retreat. Trade wars and reshoring are in the ascendency. The removal of the deflationary force of globalisation will see upward pressure on prices. Technology has been a deflationary force for the last 20 years but as some of the more monopolistic large tech businesses mature they will focus on profitability over growth and so in some sectors there will be upward pressure on prices. In others, like automation, there may be continued downward pressure on prices and wages, but this will likely be dwarfed by the aforementioned inflationary pressures from the fiscal and monetary channels plus the growing impetus to tackle income inequality.”

Charles Luke, Manager of Murray Income Trust, said: “The longer-term outlook for inflation will depend on the impact of COVID-19 on some of the secular drivers of inflation that had been in place over the past few decades. Technological progress has also had a huge bearing on inflation and will continue, intensifying international competition and suppressing wage growth.”


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