We seemingly love to overreact to things.  I’m not sure if it is a reaction to missing out or peer pressure or maybe fear and greed.  The petrol ‘crisis’ a couple of weeks ago is a great example.  It was seemingly triggered by a statement from BP and Esso saying they might have to close a ‘small number’ of their petrol stations.  BP made a similar statement in July, however this didn’t get the same reaction of panic for some reason.  Earlier this week, The Hut Group did an investor presentation, which went quite badly wrong and the share price fell by a third, or roughly a £2bn fall in the value of the business.  Did the information provided in the presentation really result in the true value of the business falling by a third?  Time will tell, however I suspect not and it is an overaction.  There is often a common thread to these overreactions, which are played out through the media.  The Hut Group has been panned this week in the media despite being the media’s darling when they listed on the London market last September.  However, the real media story at present is around inflation.  Is this another overreaction or should we actually be worried?

Last November we sold the last of our conventional developed market government bond exposure, which was our holdings in US Treasuries, after selling our conventional UK gilt exposure in October.  We changed the exposure to inflation-linked US Treasuries.  At the time, the 10 year US annual inflation expectation was at 1.7%, which at the time resulted in a negative yield on the asset we were buying.  My note at the time said “a negative real yield isn’t great, however if inflation runs hot, this could look cheap”.  Today, the 10 year US annual inflation expectation is at 2.52% and our holding has provided a total return of 6% since we bought it last November (to 14/10/21).  The conventional US Treasury holding that we sold has delivered a total return of -2.98% over the same period, a near 9% difference.  At the time, this was done for our clients with a Cautious attitude to risk and a 9% difference for a government bond holding is important for these clients.

Last November, we clearly didn’t know that the UK was going to face shortages of carbon dioxide, HGV drivers, pigs in blankets, broccoli or petrol.  However, we could see that there was likely to be a mismatch in supply and demand following the pandemic and that inflation, being a year-on-year figure could sharply rise due to base effects and the initial deflationary impact of the pandemic.  Throughout 2021 we have added to our inflation-linked US Treasury positions for all of our clients, except for those in the highest risk portfolio.

The media seem to really enjoying writing about supply problems and the potential rise in prices, especially if it affects Christmas.  Tim Harford wrote a good piece in the Financial Times this week, in which he noted “our experience was not that the price of electricity, toilet paper or petrol doubled.  It was that there was no petrol and no toilet paper”.  Whilst some prices have risen strongly recently, the majority haven’t.  For most goods and services, it’s difficult for companies to pass on the full rise in costs straight away.  They’d prefer to run out or stop production than double prices or face a collapse in margins.  However, as Harford points out, prices will likely slowly rise over time so that consumers don’t notice so much.  So are we expecting the supply issues to cause significant, consistent inflation, which becomes problematic for investors?  In a word, no.

It is important to remember that inflation is a year-on-year figure.  Therefore, we need prices to rise significantly again next year.  And the year after.  And the year after.  The huge build up in household savings could create a further boost to demand if the savings are spent but at present, there is little evidence of this.  The mismatch in supply and demand should sort itself out as producers and consumers adapt to changing conditions.  The usual way that prices are allowed to consistently rise is if wage growth rises significantly, and consistently.  Therefore, we watch wage growth carefully.  Whilst the latest headline wage growth figure of 8.3% caught the headlines, the detail is painting a different picture.  The majority of that wage growth figure is skewed by base effects (the same period in 2020 was negative wage growth) and furlough.  Clearly some sectors are seeing significant wage growth, however the employment site Indeed noted that advertised pay rates rose just 1.3% this year.  Employers that can adapt, do so.  There has been a huge spike in the number of van drivers (who have seen their pay flatline this year) due to the shortage in lorry drivers, as it’s easier and cheaper to drive vans than lorries.  Sectors such as finance, marketing, healthcare, social care and most parts of the public sectors are seeing very little wage growth.

So where does this leave us?  We think that inflation could run hot for a while, above the targets of central banks and they have little incentive to do anything about it (inflation eats away at debt), however we don’t think it’ll be high enough or consistent enough to change our investment strategy.  It is prudent to ensure that there is some inflation protection in portfolios in case we are wrong, however like the wide disparity in wage growth, there is a huge range of expensive and cheap ways to build in inflation protection to portfolios.  It feels like we are nearing the peak of media overreaction in respect of inflation and supply issues and think it could be dangerous to lock in some over-hyped valuations in some inflation-linked assets.

The majority of our portfolios have inflation-linked targets, as inflation is likely to be the biggest financial risk you face in your lifetime.  If you want to have a chat and learn more about how we manage inflation risks, feel free to get in touch with any of the team.

Thanks for reading.