Inflation – the latest fad or the theme of the future?

Whether inflation will rear its head in a sustained way remains the big question for investors – Callum Stokeld, Kepler Trust Intelligence

 
In 1859 Abraham Lincoln, in one of his less prescient calls considering that whole ‘civil war’ episode that followed, recounted the classic fable of the Eastern monarch who, desiring to soothe his anxiety and depression, requested his wisest advisers engrave an idiom onto a ring to which he could turn for comfort.

This being pre-lockdown, why, in the search for wisdom and anxiety-relief, he didn’t simply head down to the pub like the rest of us remains unanswered, but the advisers supposedly came back with a ring engraved with ‘this too shall pass’.

Generally this has been taken to be a fable, but there is a growing school of thought that suggests it is in fact a solid basis for economic policy.
 

‘Repeatedly expressed the belief that inflationary pressures are transitory; they too, shall pass’

 
Federal Reserve chairman Jerome Powell, for example, has in his press briefings repeatedly expressed the belief that inflationary pressures are transitory; they too, shall pass. Clearly he has acquired the legendary ring.

In some respects, he is likely correct. We may be commodity bulls in general, but the base effect of the COVID-19 crash means the read-through impact on inflation of, for example, a c. 66% year-year increase in the S&P Industrial Metals Spot price index or a 61% increase in the AGRI INDEX (to 27/05/2021), is highly unlikely to be repeated at the same rate on an ongoing basis.

Cyclically, higher inflation expectations typically boost ‘value’ style investing relative to growth or quality, as discount rates are adjusted upwards and more immediate sources of value realisation become more attractive. A lot of market commentary around potential market rotation currently revolves around nearer term pressures. What, however, is the outlook for structural inflation?

Cyclical factors undoubtedly remain important, but sustained higher inflation will likely require demand-led inflation as well as supply constrained. Wage inflation will undoubtedly be important in this regard. Developed economies are, after all, driven by consumption. Capitalist economies should see the marginal choice of the consumer drive efficient selection of superior products and services.

However, when marginal propensity and ability to make consumer decisions falls, productivity should ipso facto decline as price becomes a greater determinant than value in consumption decisions. Demand-led inflation will require consumers to have marginal propensity to determine consumption choices.

Karl Marx averred that capitalist cycles ultimately led to increased concentration, monopolistic practises and the eventual collapse of capitalism as too great a share of production was retained as profit but reinvestment would be unable to generate returns and yet would remain too extractive to be sustained.
 

‘All of a sudden value-focused investors… will be enjoying structural tailwinds’

 
Soviet economist Nikolai Kondratiev, by contrast, showed that long-cycles of rebalancing between income and capital helped maintain ultimate social equilibrium and preserve the system. Sociological studies have suggested similar long-cycle dynamics in societal structures.

For example between 1991 and 2019, the labour share of GDP across the USA, Germany, Japan, the UK, China, France, Italy and Spain, fell by an average of c. 3.7% (Source: St Louis Fed). This also does not account for marginal propensities to spend, with divergences in income trends in favour of the very top-earning brackets.

Were this to reverse, in contradiction of Marx and in support of Kondratiev, input cost inflation from wages are likely to rise, but moats are also likely to decrease as supply chains are shortened (and the ability to arbitrage costs across jurisdictions decreases). This further feeds a positive feedback loop of rising wage pressures, and likely higher costs.

Structural inflationary pressures certainly, if the market truly believes in them, should pose a tailwind to value by shifting the market demand incrementally towards more immediate realisation of value.

Yet Fed Chairman Powell’s favourite word seemingly remains ‘transitory’ for this time, and markets seem largely inclined to believe him. This seems, however, to overlook his comments on 10/02/2021, which included that the Fed would target full employment. Perhaps most importantly, he noted that many of the benefits of a strong-labour market only arose towards the end of the previous expansion; the Fed is telling us they will run policy ‘hot’.

If we are truly seeing a new prioritisation in policy making towards wage inflation, particularly at the lower end of the wage spectrum (see also Janet Yellen’s recent comments), then the structural inflation backdrop could shift to a new epoch where price pressures trend higher. All of a sudden, value-focused investors such as the managers of the Momentum Multi Asset Value Trust (MAVT) and the managers of their preferred underlying funds, will be enjoying structural tailwinds.

Borrowing from Ricardo, and his ‘labour theory of value’, this increase in cost control on the side of labour can drive profit expansion without the same deployment of strategic leverage to fund capex.

If we now reverse this and see diminishing labour cost control, productivity boosting spending will need to increase. Of course, public markets are generally quite appreciative of this anyway, and publicly listed software-as-a-service companies typically trade on very elevated valuation multiples.

Yet there remain a raft of other unlisted opportunities investors to take on exposure to a whole host of potentially productivity boosting technologies and services.

We note, for example, that NB Private Equity (NBPE) contains a multitude of such companies, offering solutions in software areas such as security, education, and IT infrastructure. These seem like likely beneficiaries of increased capex spending.
 
Read the latest research on Momentum Multi Asset Value here >

Read the latest research on NB Private Equity here >

To buy these trusts login to your EQi account

Select: Momentum Multi Asset Value Trust – GB0008769993

NB Private Equity – GG00B1ZBD492

 
Material produced by Kepler Trust Intelligence should be considered as factual information only and not an indication as to the desirability or appropriateness of investing in the security discussed. Kepler Partners LLP is a limited liability partnership registered in England and Wales at 9/10 Savile Row, London W1S 3PF with registered number OC334771. Full terms and conditions can be found on www.trustintelligence.co.uk/investor