So much has happened since January when we last updated our view of the markets, that it is perhaps time to take stock again. The biggest changes are of course:
War in Europe
This came as a shock to almost everyone and there is no relevant experience on which to draw. After nearly three months, it begins to become possible to discern some effects:
- Severe disruption to supplies in several areas where Russia and Ukraine are significant exporters such as energy, food staples such as wheat and oil, and timber but the range is limited as their contributions to world GDP are otherwise very small.
- Some disruption to financial flows from sanctions.
- These contribute further pressure on costs that were already rising, so inflation is now at levels not seen for decades and still rising.
Inflation
Costs were anyway rising as the world (or most of it except China) emerges from the pandemic. These mainly result from disrupted supply chains and are being compounded by “reshoring” and the shortening of supply chains as companies realise how vulnerable they are to all kinds of disruptions. These factors will continue to raise costs and the benefits will not be seen for years. On that basis, we should expect higher inflation for the next few years.
The energy cost and food supply problems have produced an additional shorter-term uplift to inflation which is likely to be of more limited duration. Oil and gas shortages/price rises are giving significantly increased impetus to the expansion of other sources of energy, particularly renewables, which can be delivered in the medium term, but also new nuclear, which is always long term, so not actually much help now. In the short term, there are palliatives available like pumping more oil from existing facilities, better use of LNG capability, delaying decommissioning of existing nuclear and coal plants.
The combined effect of these factors suggests severe pain in the short term, particularly this winter, say with inflation of perhaps 10%+ pa, but in the medium term, a return to 4-5% pa, which is manageable.
Portfolio construction
We are against changing portfolios to counter short-term problems as the costs almost always outweigh the gains, particularly when the difficulties of making short-term judgments are considered.
Making sure that portfolios are properly positioned for the medium term is essential and that means focusing on investments which are, at least to some degree, sensitive to the medium-term outlook for inflation. As we have been expecting this for at least a year, that is generally already the case, with negligible Cash or Fixed interest holdings and heavy emphasis on Equities, Property, Infrastructure, Renewables etc. Each investment must be tested for its likely response to moderate inflation because 5% inflation represents the majority of the total investment return to be expected in the short run.
Equities: They represent real businesses and, if companies have pricing power in their markets, results should not be badly affected.
Property: Most commercial leases have incremental provisions, of course only effective if tenants can pay. Residential property values have generally increased by more than inflation, as have rents.
Infrastructure: Most contracts have inflationary clauses in them or are tied to markets that are dynamic.
Renewables: Income is either subsidised on an inflation-linked basis or is from selling electricity into markets that are projected to increase in real terms.
Opportunities
As we have always advised, a long-term outlook is always needed when investing; another equally important factor to go with that is patience. This is further emphasised when we see statistics like the one below:
Volatile and unpredictable markets often throw up opportunities where investments seem to be mispriced by the market based on short-term factors like fear, misinformation, herd-following etc. We do, of course, look out for these and will highlight them where appropriate.
This note is intended to be a general market update and should not be construed as a recommendation to invest in any particular fund or asset class. If you would like to discuss the implications for your own portfolio, please feel free to ring or email us.