This is the final in a series of three blogs on inflation, interest rates and investing.
In our previous post, we introduced the idea that asset values in a diversified portfolio are largely determined by three factors: an exposure to growth, an ability to protect against inflation (or deflation) and a sensitivity to changes in real interest rates. But each asset class in a portfolio has a different sensitivity to each factor and no single asset class is usually capable of achieving all investment objectives as economic settings change. In this final episode we explain the relationships between growth, inflation and interest rates and how they combine together in certain economic settings with historical examples. We then pull it all together - what asset classes might behave best in each of these settings?
Let us first look at what normally drives inflation. As the economy grows and business profits and consumer confidence grow along with it, the demand for resources, materials, finished goods and labour services increases. Accordingly, these goods and skilled labour become harder to find. Capacity constraints and inefficiencies emerge. Meanwhile, buyers are more willing to endure price rises in a growing economy. Thus, inflationary pressures naturally rise in a growing economy. Conversely when the economy is weak and the consumer and businesses are less confident, demand falls and capacity is freed up, meaning inflation usually subsides or there is even deflation.
The real interest rate is determined by how much supply and demand there is for capital to borrow, invest or spend which in turn, is determined by all manner of factors. All else being equal, as an economy grows, there is a greater demand for capital. Capital is required to fund expansion of infrastructure, to buy new plant and equipment or to fund consumer spending as people feel more confident about their prospects. Growth in the economy therefore causes the price of money/capital i.e., the real interest rate, to rise. Likewise, if there is a decline in business and consumer confidence as the economy weakens, this reduces the demand for capital and generally causes real interest rates to fall.
Central banks are also tasked with keeping inflation low, dampen inflationary pressure by manipulating the real interest rate, tightening bank lending standards and reducing the money supply. Raising the real interest rate above those natural forces of supply and demand will cool the economy and release pent up steam as capital becomes more expensive to use. Higher real interest rates focus borrowers on whether they really want to spend money on that new piece of machinery or borrow money to build that new house, invest in riskier investments or instead save at lower risk at relatively more attractive rates after inflation. Likewise, real interest rates will be reduced to stimulate demand in an economy when in a recession to reduce the chance of damaging deflation.
Accordingly, owing to the influence on economic growth on both inflation and real interest rates and the presence of central bank inflation-fighting mandates, there is usually a strong positive relationship between inflation, economic growth and real interest rates. That is, inflation and higher real interest rates are usually synonymous with a growing or an even booming economy. And low inflation, deflation and low real interest rates are typically associated with a low growth economy or one in recession. This is depicted in the diagram below: real interest rates and inflation tend to move up and down at the same time, because they are related to the typical boom or bust growth cycle of the economy.
There are times however, when real interest rates and inflation rates move in opposite directions. The first of these less usual scenarios is a ‘deflationary growth’ scenario. Here, usually owing to a what economists call a “positive supply side shock”, such as a new technology, a new abundant source of energy, mass migration, working population growth or trade liberalisation, economies can grow without serious capacity constraints and avoid the boom-bust cycle. The UK Industrial Revolution is the classic example of an overall period of deflationary growth. With advances in technology, a young and growing population and trade, goods became mass produced and cheap. Meanwhile, the demand to build new factories, railways and shipping led to high real interest rates as demand for capital was also very high.
The second, less usual scenario is where high inflation exists alongside low growth and low real interest rates, i.e. ‘stagflation’. Stagflation often occurs after a period of high growth and debt accumulation that leads to overheating or a “negative supply-side shock”, such as a trade war, over-regulation or energy price hike. Central banks may choose not to fight the emerging inflation, prioritising other policies instead or fearing a recession and the opprobrium of their political masters. Without the central bank providing a necessary handbrake, high wage and inflation expectations then become ingrained but growth eventually becomes constrained as private sector investment decisions, already weighed down by excessive debt and discouraged by high inflation uncertainty, are often crowded-out by high government spending. Bottle necks continue to emerge, companies fail, unemployment increases and productivity collapses. Private sector demand for capital declines and real interest rates fall further. This rather gloomy scenario is New Zealand and the UK during the 1970’s and early 1980’s. Stagflation also readily emerges through unconstrained money printing and profligate government spending off the back of it. Venezuela is a recent extreme example of this in a long list of South American economic woes.
In summary, the framework of inflation and real interest rates can be roughly divided into four quadrants with historical examples in the diagram below.
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So how do these economic environments translate into appropriate asset allocation strategies? As per our discussion in Part 2, in an inflationary boom with growth causing rising real yields and inflation, your portfolio benefits from being overweight asset classes that are more responsive to growth than the negating impact of rising real yields has on valuations, but which also have the ability to protect the investor against inflation. Growth oriented infrastructure e.g. airports, power generation, toll roads along with blue chip companies, commercial property with short or inflation adjusted leases and banks who are able to pass on and even profit from inflationary pressures, should all do well. Commodities/energy and cyclical equities are likely to also perform, as might property development. Equally these asset classes will not perform well in a deflationary bust. Here, high quality government bonds, long term commercial property leases to high quality tenants, certain investment grade corporate bonds and defensive and counter cyclical equities (e.g. supermarkets, discount stores) are likely to perform as their stable cashflows are made relatively more valuable when real interest rates fall and if inflation falls below expectations.
In less usual deflationary growth periods, smaller growth orientated companies understandably perform as these periods create space for new entrants and disruptors, outweighing the drag of higher real rates on their future cash flows. Riskier, high yielding credit with short maturities e.g. leveraged loans also perform as leveraged companies do well in growth environments whilst the exposure to rising real rates is relatively muted in comparison.
In stagflationary environments there are few asset classes which do well. High quality inflation-indexed bonds are an obvious contender as are more defensive infrastructure assets which offer good inflation protection and stable cash flows.
The diagram below summarises some of the above mentioned asset classes which might tend to perform best in these four general scenarios. But these preferences are all relative to other available asset classes – returns might still be disappointing but just better than the alternatives. Importantly, outcomes also depend on whether the asset class already incorporates that particular scenario into its current price. Nor does it suggest that portfolios should abandon asset classes altogether for more favoured ones as no one can reliably predict where the economy will be over any reasonable investment horizon.
The overarching message here is that in an uncertain world, the case for a diversified and liquid portfolio that offers flexibility and protection, against not only inflation but also the ups and downs of the economic and interest rate cycle, is crucial. Investors need to be especially aware that focusing on just one aspect of an asset class’s attributes without considering its other characteristics may lead to disappointing outcomes overall, particularly when you consider the returns after inflation.
To read part two in this series on inflation, interest rates and investing, click here.
This article is intended as general information purposes only and is not, nor should be considered, financial advice or recommendations. Where the author expresses opinions, this should not be taken as financial advice for any individual. It should not be used as a substitute for seeking professional financial advice which takes into account your personal financial goals and circumstances.
Independent Member of the Quartz Investment Committee
Date published: 10 December 2021
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