Will lower systemic growth and inflation become the norm once again?
Trending lower inflation rates around the world for many years prior to 2020, meant the word “inflation” was less prevalent amongst the investing community. This year, “inflation” is one of the words most bandied about in markets. For some investors it is a concern, and for others it represents an opportunity.
A cyclical recovery has brought relatively high growth rates worldwide in 2021 as markets emerge from a year of lockdowns. Economic indicators, both globally and in SA, are indicating inflationary pressures over the short term. We believe however that from 2022 (post the cyclical recovery), growth will slow and inflation will revert to previous levels. This is because the underlying structural factors that kept inflation low pre-Covid-19 are still in place.
Growth beyond a cyclical recovery?
Global trend growth since 1980 has been around 3.5%. Beyond 2022/23 we expect global growth to revert to these levels or shift lower following the highly stimulatory environment.
There are two key factors that are negative for structural long term growth:
1) Government’s recent support to protect economies
The classic accounting formula: assets are equal to shareholders’ equity plus liabilities can be applied. Governments stepped in taking on more debt (liabilities), thus protecting business and the consumer from the dramatic impact of the pandemic and consequently driving up asset prices. In our view this will depress growth in future primarily because high government debt levels adversely impact investor confidence.
Since the 2008 global financial crisis, when the US government stepped in to protect households and financial institutions from the consequences of excessive borrowing in the preceding years, government debt has been increasing as a proportion of GDP. After the recent pandemic, the US government took on even more debt, and it currently stands at over 120% of GDP.
Normally, a recession is followed by an investment boom, because asset prices have corrected. This is not expected to happen this time around, because asset prices and the available capacity have not adjusted downwards. In real terms, the global asset base is inflated in relation to underlying GDP.
A longer-term structural factor impeding growth is the ageing population in developed countries, with Japan providing empirical evidence of what that means for economic growth.
Will inflationary pressures ease off meaningfully?
The key factors contributing to inflation or disinflation are summarized in the below table. The short term current cyclical spike we believe is driven by transitory changes while more persistent lower levels of inflation beyond the recovery can be explained by more sustainable structural forces. Changing dynamics within employment, the supply of goods and services and the cost of energy are all important factors to consider.
Driving current inflation spike
Post recovery: lower inflation for longer
Americans have shown a reluctance to return to the workplace, partly because of generous handouts to the unemployed and partly because of fears of infection
A trending slack in the labour market is more structural in nature and we think this will persist, as corporates have focused on technology and cost-cutting in recent years.
Supply of goods and services
Supply bottlenecks as a result of shutdowns. There were shortages of some inputs such as shipping capacity and lumber, but these shortages are unlikely to persist as economic activity.
Companies have been propped up by government debt during the pandemic crisis. The number of bankruptcies and liquidations have been relatively low through the pandemic, which means limited downward adjustment in capacity during a recessionary period. Longer term the supply: demand equation will need to re-balance.
Sharp recovery as a result of supply cuts. Since Covid-19 there has been less local and long-distance travel, both as a result of nervousness about travelling but also impacted by the shift to working from home. This implies a lower level of oil utilization in the economy.
In future, we see intensity of oil use remaining at lower levels, which is likely to keep the longer-term price of Brent crude at around $65/barrel and will cap inflationary pressures.
Inflation rate expections for the US and SA are depicted in the charts below. Breakeven inflation expectations for the US are above 2.5%, but they are likely to return to below 2% in the longer term.
From an SA perspective, inflation rate remains well contained around 4.5%. which is important for interest rate levels and therefore asset allocations within local funds.
Our conviction that inflation expectations are potentially overstated at current levels and likely to moderate in future years impacts the level of interest rates and the extent to which policy will increase rates. And implies future interest rate increases will be lower than expected.
Positioning our portfolios
Our views on structural forces driving lower inflation means we favour long-dated local and global bonds. SA’s government debt levels have ballooned, but fortunately strong metal prices have supported tax revenue collections and fiscal health. We are also seeing positive political developments and indicators of longer term economic growth. These factors, coupled with a low inflation outlook, favour longer-duration SA bonds. In global markets, we particularly like Emerging Market bonds in countries including Mexico, Indonesia and Columbia.
SA equity retains exposure to selected industrial and financial shares but we started adding gold miners at the end of 2020, given gold’s status as an investment hedge and South African gold miners’ leverage to the gold price. In diversified miners, we are exposed to iron ore, and we also like platinum miners.
A lower inflation, lower developed market growth and lower interest rate environment post the cyclical recovery also favours global equity assets and particularly the quality growth companies. Investors tend to pay a premium for quality assets that can grow stronger and deliver sustainable returns in an environment where structural growth is lower and inflation contained with interest rates at lower levels.
Our global equity portfolio now includes Emerging Market and European equities, which we think will gain from cyclical recovery in future years. These regions, which sell to the US and China, will benefit from the government stimulus in those major markets.
The outlook for inflation and growth are interconnected. Our view that inflationary pressures will ease and global growth will trend lower post this cyclical recovery drives a strong conviction around portfolio construction to ensure we deliver consistent risk adjusted returns. Our track record for the STANLIB Balanced Cautious Fund clearly demonstrates the benefits of portfolio diversification in delivering stable long term returns over various market cycles, having only delivered only one negative year of returns, and in many other years double-digit returns.