Inflation is like toothpaste. Once it’s out, you can hardly get it back in again.

VT Tyndall Unconstrained UK Income Fund

Inflation is like toothpaste. Once it’s out, you can hardly get it back in again.

As we head towards the final quarter of 2021, we return to one of the critical investment topics of the day, inflation. For several months the debate has been raging as to whether the elevated inflation we have witnessed recently is simply transitory in nature and will pass as the world fully re-emerges from lockdown and supply chain bottlenecks subside, or whether it might genuinely be different this time compared to the persistent deflationary experience of the last 40 years or so.

For choice we are more inclined towards the ‘stickier’ argument than we are to the ‘transitory’ one and the quote above, from distinguished German economist Karl Otto Pohl, neatly encapsulates our thinking. Nevertheless, in recent months the transitory camp, ably cheered on by the world’s central bankers, has seemingly been winning the argument – certainly if the behaviour of bond yields and the performance of long duration equities has been anything to go by.

The fact that bond yields have recently been declining and growth/long duration equities have been outperforming has been a bit of a puzzle to us, in the face of relentless inflationary pressure signals. Perhaps the starkest illustration is in the chart below, highlighting the change in US CPI inflation compared to the level of US 10-year Treasury yields over the last 12 years.

It certainly doesn’t seem to us like these inflationary pressures are showing any material sign of easing anytime soon either, as the next couple of charts illustrate.

The chart above shows the number of S&P 500 companies highlighting inflation as a significant issue during quarterly earnings calls over the last 5 years. Meanwhile the chart below, of the widely followed Baltic Dry shipping index, has recently reached its highest level in 12 years.

A similar message can be seen in the chart below of input price pressures for UK construction firms over the last 20 years.

Perhaps the key to solving this conundrum lies in the chart below. Whilst inflationary pressures have remained elevated, it is certainly the case that economic growth data points have been somewhat disappointing over the summer, most likely a combination of ongoing supply chain issues and additional disruption caused by the global surge in the ‘delta’ variant of Covid-19. It is, perhaps, no wonder that ‘stagflation’ has become a much more widely discussed topic recently!

Why do we consider these issues so important from an equity investment perspective? Put simply, the direction of bond yields has a profound effect on the performance of many sectors within the equity market and in particular on the relative performance between ‘value’ and ‘growth’ factors. As can be seen in the chart below, the last few months of falling yields has corresponded with underperformance, once again, for value relative to growth globally.

So where do we head next? Interestingly, bond yields appear to be making a concerted attempt to break out once more as the 2 charts below of US and UK 10-year bond yields highlight.

There are a number of potential contributing factors for yields to start to break out again but to us a key one is the persistence of the inflationary pressures we have illustrated above. Additionally, having disappointed over the summer it seems likely, as the chart below suggests, that economic data points will start to surprise more positively soon.

Throw in the potential for central banks to start withdrawing their ultra-easy monetary policies in the near future and the stage would seem set for higher yields. How much higher will undoubtedly be the next debate but, with economic growth likely to remain robust in our view, the scope, as the chart below suggests, is considerable.

In summary, we think it more likely than not that the environment is fundamentally changing from the low growth, low inflation, ever lower bond yield backdrop that has dominated the investment landscape for more than a decade. If we are right, the winners of the future will be significantly different to those of the recent past, with ‘value’, after years of substantial underperformance, becoming a successful factor once more. We believe our portfolio is exceptionally well placed to thrive in such an environment. We wonder how many others currently are.

30th September 2021
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This content is intended for professional clients only.

Data source (unless otherwise stated): Bloomberg.
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