Seek out value to shelter from stubborn inflation

(Image credit: Rob Arnott)

published 16 October 2023

Andrew: Let’s start with inflation. You pointed out recently that US inflation is set to rise from its summer low this year.

Rob: Yes, this is certainly not a time to pop the champagne. Investors always seem to forget about the base effect, which is the reason US inflation is heading back up. Our prediction, assuming modest half-percent inflation per month over the coming months, is that it is set to finish the year between 4.5% and 5.5%.

It has already ticked up from July’s 3.2% to 3.7% in August. We are replacing near-zero inflation in the second half of last year with non-zero inflation in the second half of this year. So markets may well find the trajectory of the next few months disconcerting.

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More broadly, you have done a study tracking inflation in 14 developed economies between 1970 and 2023. What is the key takeaway?

Rob: Inflation that has exceeded 8% is rarely benign or transitory. There were 31 episodes of 8% inflation. If it crosses 8% but doesn’t eclipse 10%, history suggests that it can dissipate in relatively short order, less than four years.

But it’s important to note that that’s based on just one case. And there were nearly 20 samples of inflation going above 10% before declining to 2%. But that tends to take about 15 years on average.

And inflation won’t dissipate until the underlying causes of inflation are resolved. If you have a little inflation, say 4%, the causes can be exogenous shocks; once the shocks wear off, so does inflation. But if it’s above 8%, it’s almost always due to policy blunders.

Andrew: That prompts my next question, which is that you have reminded people that inflation is a matter of demand exceeding supply in an economy. So we had money printing and government spending fuelling demand on the one hand, and upended supply chains following lockdowns on the other.

Rob: And we now have slightly less deficit spending and supply chains are recovering, but still not completely fixed.

So inflationary pressure is still there; moreover, there may not be much more rapid improvement on either the demand or supply side as far as tempering inflation is concerned. “Supply-side”, or structural reforms such as deregulation, can boost productivity and hence improve economy-wide supply, but they are politically unpopular.

And on the demand side, central banks may be hesitant to squeeze out inflation the way Paul Volcker did in the 1980s, given the huge debt loads we are grappling with today. The US Federal Reserve is certainly behind the curve.

We are in for a period of elevated inflation, then.

Rob: I think so. And then the question is, what does elevated inflation do in terms of investment opportunities? It tends to be a risk-off environment where risky assets don’t perform well. Because there’s no such thing as elevated but stable inflation.

So growth stocks take a back seat – higher interest rates reduce the present value of future earnings – and investors turn to value, the solid earners that pay dividends. Safety now, over future growth.

And the great news is that value is currently extraordinarily cheap compared with growth thanks to the excitement over artificial intelligence (AI). It has only been this cheap in relative terms at the peak of the technology bubble in 2000, and in 2020 and 2021.

Some companies are cheap for a reason, of course – they might go bust. But some are perfectly robust, just deeply out of favour. With value so cheap in absolute as well as relative terms, it could prove massively profitable.

Is value cheap globally, not just in the US?

Rob: Yes. Non-US value stocks are on 12 times their average earnings over the past ten years (I like to use ten-year earnings so I can smooth out the impact of the economic cycle).

Emerging-market value is on just ten times cyclically adjusted earnings. Emerging markets comprise half the world’s GDP. When you can buy half the world’s output for ten times earnings, that’s a wonderful thing.

Are there ways to track these value sectors?

Rob: Investors might research the series of exchange-traded funds (ETFs) from Invesco that focus on value. There is the FTSE RAFI All World 3000 Ucits ETF (LSE: PSRW) for a global play; the FTSE RAFI US 1000 Ucits ETF (LSE: PRUS) for US value; and its European counterpart the FTSE RAFI Europe Ucits ETF (LSE: PSRE).

The FTSE RAFI UK 100 Ucits ETF (LSE: PSRU) is a British version, and the FTSE RAFI Emerging Markets Ucits ETF (LSE: PSRM) explores value in developing countries.

Let’s move on to the biggest emerging market, China. We’ve been worried for some time that it could get old before it gets rich.

Rob: I think it probably will. I would love to see it be prosperous, as prosperity tends to cross borders. But President Xi is an unreconstructed Maoist, a command-and-control leader. And the result is a Maoist-induced slowdown in the economy . Under Mao, the Chinese economy was dreadful.

Under Deng Xiaoping, who introduced the free market to the country, it was spectacular. And under Hu Jintao, who copied some of the same policies of Deng Xiaoping, although he introduced more strictures than before, growth slowed from 15% a year to 7% a year. That’s still pretty stupendous.

Under Xi it could stall because of his Maoist instincts. And because of his sabre-rattling and a tendency to squander national wealth on foreign adventures and interference. This is all very dangerous, but also very self-inflicted.

We seem to have a balance-sheet recession, so it will be hard just to blow up the credit bubble again. As the economy struggles, is the state more likely to be militarily adventurous to distract people?

Rob: The odds of that are elevated when you have policy blunders you need to distract people from. I feel that if Ukraine had gone well for Putin, the next to fall would have been Taiwan, and probably fairly quickly.

But I think the quagmire in Ukraine has made President Xi think twice. I wouldn’t rule it out, though I feel the odds are less than they were two years ago.

Andrew: People are starting to realise that emerging markets don’t automatically emerge. China could well get stuck in the middle-income club. Japan, Taiwan and Korea went from poor to rich.

Rob: Don’t forget Singapore. It was poorer than Malaysia back in 1960. Now it’s 70% richer than the United States, per capita. The recipe for success is actually incredibly simple. You get out of the way of the private sector, and the private sector produces what people want.

Then you get prosperity. Singapore is an interesting example because much of the population is Chinese. And the Chinese entrepreneurial mindset is deeply rooted. When Deng Xiaoping simply got the state out of the way, all went well.

So the China bubble has well and truly burst. What about the AI bubble? It presumably is a bubble?

Rob: This resembles early 2000 in so many ways. The idea was the internet would change everything. The way we buy and sell goods and services.

The way we do research. The way we get our news and communicate. And so on. And don’t worry about price/earnings (p/e) ratios because the earnings will rocket as the world embraces the internet.

Now, that narrative was spot on. The only thing it was wrong about was the timeline. It didn’t happen in two years, it happened in 15 or so. It was gradual. The internet has changed everything. AI , too, will change everything.

AI will kill millions of jobs, which 20 years later, we won’t miss. It will, for the first time, kill millions of highly skilled jobs that involve some brain work. But every innovation destroys jobs and boosts productivity massively.

Nobody is going to lose a job to AI. They will lose a job to someone who knows how to use AI to leverage their own productivity.

There has also been talk about using AI to pick stocks.

Rob: AI depends on vast data. If you have thousands of pieces of data, AI is useless. If you have billions, it can work. So, AI is already utterly dominant in high-frequency trading. But when people talk about using AI to make stockpicking choices for longer-term investing, that’s crazy. AI doesn’t have enough data to exceed the efficacy of human judgement supplemented by ordinary statistical tools.

Andrew: Yes, it seems that what is so valuable is, for instance, that it can crunch data so fast that it can probably find drug combinations that we can’t. That sounds genuinely helpful.

Rob: The range of applications of AI is huge. But it doesn’t include things like better predicting whether we’re going to have a recession next year.

Andrew is the editor of MoneyWeek magazine. He grew up in Vienna and studied at the University of St Andrews, where he gained a first-class MA in geography & international relations.

After graduating he began to contribute to the foreign page of The Week and soon afterwards joined MoneyWeek at its inception in October 2000. He helped Merryn Somerset Webb establish it as Britain’s best-selling financial magazine, contributing to every section of the publication and specialising in macroeconomics and stockmarkets, before going part-time.

His freelance projects have included a 2009 relaunch of The Pharma Letter, where he covered corporate news and political developments in the German pharmaceuticals market for two years, and a multiyear stint as deputy editor of the Barclays account at Redwood, a marketing agency.

Andrew has been editing MoneyWeek since 2018, and continues to specialise in investment and news in German-speaking countries owing to his fluent command of the language.