How to invest if central banks can't control inflation

The consequence for investors will be that only a very narrow range of income investments will perform well, according to Bruce Stout, who runs the £1.8bn Murray International investment trust.

In the latest factsheet for the trust, Stout wrote that markets and policy markers are “ignoring” the “wider picture” which is that inflation will be higher than most investors have previously experienced, even if it falls from here.

Stout wrote: “As the financial world obsesses about predicting ‘peaks’ in inflation and interest rates, it seems very few are prepared to consider the wider picture. 

The vandalism that was quantitative easing proved an opium for asset prices.Bruce Stout

"For an investment generation unfamiliar with inflation, the compulsion to firmly hang onto the belief in a swift return to the ‘2per cent mean’ of the past decade remains all-consuming."

He said such delusion is not confined to just financial markets and investors either, since practically every discredited central bank in the developed world is currently peddling this unrealistic message of 'returning to the 2 per cent trend'.

The most recent forecast from the UK’s Office for Budget Responsibility predicted that UK inflation, currently over 10 per cent, would fall to 2.7 per cent.

In contrast he feels that in the world outside of financial markets, rising rents, mortgage rates and index -inked prices mean the mindset of consumers now differs from that of investors, as they have become used to inflation as a phenomenon for the first time.  

Beginning and ending the inflationary spiral

Stout believes that where this conflict will be played out is in the labour market.

Workers, scarred by the current impact of high inflation, will be more aggressive in their wage demands, meaning future inflationary pressures will be greater, regardless of central bank actions.

However, he feels markets are ignoring this and trusting central bankers.

Stout also believes central bank quantitative easing policies began the inflationary spiral, and believe that reversing QE will reverse the spiral, but the change in consumer mindset means the die has been cast, and questions and forecasts around the short-term trajectory are not relevant. 

Such naïve monetary policy is no longer sustainable under evolving economic circumstances.Bruce Stout

Quantitative easing is a central bank policy to expand the quantity of money in an economy, and policy makers use higher interest rates and quantitative tightening to reduce the money supply in what they hope is an orderly manner and at a pace which doesn’t tip economies into a deep recession. 

Nadège Dufossé, global head of multi-asset at Candriam, says this attempt at timing is complicated by the turmoil in the banking sector.

Her view is that the risk is inflation collapses, at least in the short-term, at a pace which is faster than central banks want, and so an economic slowdown occurs. 

She says the collapse of Credit Suisse and SVB bank will cause commercial banks to tighten their lending standards, a sharp reduction in lending by commercial banks has much the same impact on the real economy as if interest rates rose very sharply. 

In this scenario, inflation falls due to a lack of supply of credit, and pushes economies into a sharp recession. 

Investment implications 

In terms of what this scenario means for investors, Stout says he is investing in defensive equities in areas such as emerging markets, where the growth picture is different, and in stocks that are exposed to “real assets”, such as commodity companies, and infrastructure assets such as the equity or airport operating companies. 

Stout comments: “The vandalism that was quantitative easing proved an opium for asset prices and a smoke-screen for deeper economic distortions which it created and which would eventually manifest themselves. Now the inflation that printing money inevitably caused is the inflation that has ultimately killed it.

"Such naïve monetary policy is no longer sustainable under evolving economic circumstances simply because Government balance sheets are close to breaking point. What follows next could potentially become the most significant change to monetary policy since the early 1980’s.”

He added: “Should fundamentals be free to price risk going forward from here, the practice of reducing central bank balance sheets has broad implications for long-term equity multiples (lower), prevailing bond yields (higher) and optimal stock selection.

"Without dramatic improvements in productivity it’s reasonable to assume equity valuations based on profitability, cash flows and dividends would in general be reflective of lower economic growth, and would favour profits today rather that promises tomorrow.” 

If investors do, as a result of fears around the outlook for inflation over the longer-term, prioritise earrings today, rather than the promise of future earnings, that would involve investors buying value, rather than growth stocks. 

Mattias Born, chief investment officer at Berenberg Wealth and Asset Management says the era of low interest rates and low inflation helped growth stocks at the expense of value, but in a world of higher inflation, he would expect this to reverse. 

But he also feels that as a consequence of higher interest rates, the more cyclical type of value equities will do badly, and so is sticking with defensive stocks in areas such as pharmaceuticals. 

Duffose and her colleagues have responded to the risk of a sharper downturn by focusing on defensive areas of equity markets in areas such as consumer staples, but has increased the duration of the bond exposure in portfolios.

Longer-duration bonds tend to perform best when inflation is expected to be lower in future than now.

Central banks are walking a tightrope as they try to curb inflation without tipping economies into recession, but it may be that events outside of policy makers control have the greatest impact on income investors portfolios in the years to come. 

David Thorpe is investment editor at FTAdviser