How to position your portfolio for lasting inflation

Inflation is the hottest topic in markets right now.

There are lots of “ifs”, “buts” and “maybes” involved. Are today’s inflationary pressures really sustainable? What happens as we learn to live with Covid rather than locking down every five minutes? Can higher interest rates do anything to help untangle supply chains, or cut energy costs? (No).

They’re all important questions, but all of this debate misses one key point about why inflation might be more persistent than expected.

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Which is this: it’s the most politically convenient outcome.

Inflation is a key part of the solution

In a recent paper, “Inflation is Here! What Now?”, Chris Brightman of Research Affiliates points out that all across the globe “deficits are ballooning, government debt is soaring, and inflation is spiking”.

If you look at the G7 countries (US, UK, Germany, France, Canada, Japan and Italy) then, on average, “total debt levels as a percentage of GDP have doubled from 80% in 1995 to over 160% in 2020”. The biggest increase in debt happened last year, with debt levels rising at rates that outstripped even the “surge during the 2008-2009 global financial crisis.”

Deficits (the annual gap between spending and tax revenues) have also exploded. In the quarter-century to 2020, the average G7 deficit was 3% of GDP. It’s worth noting that in historical terms, a 3% deficit has always been seen as playing with fire. Yet in 2021 the average spiked to a deficit of 10%.

Now, most of this action was justifiable, certainly in the early days of the crisis. If the state chooses to close businesses down, it has to recompense those businesses and their employees for lost earnings – that’s only fair.

But it means that government balance sheets are looking tattered. That’s sustainable when they all look like that, but, as the pandemic era ends, the process of balance -sheet repair needs to begin. The tricky thing is how to do that.

More than any other factor, this huge public debt problem is key to why inflation – rather than being a problem – is in fact part of the solution (from the state’s point of view at least). Central banks might be able to withdraw quantitative easing (QE) but interest rates cannot go much higher – “the G7’s finances cannot afford nominal interest rates above current inflation rates”.

Raising taxes is another option, but that’s not going to be popular at a time when prices are going up too. As a result of this unpleasant dilemma, politicians might well decide that “sustained inflation may be the expedient political path to diminish the real value of excessive public debt”.

(Put very simply, if inflation is rising faster than interest rates, then the cost of your debt falls with each year, because your interest costs aren’t rising as fast as inflation.)

Buy value, sell growth

Brightman also makes the point that while withdrawing QE may not help to lessen inflationary pressures much (if it mostly inflated asset prices rather than affecting the “real” economy, then there’s no reason to expect it to hugely affect the “real” economy on the way out either).

However, it does mean that the possibility of a liquidity-driven “incident” is higher. In other words, markets dependent on lots of excess liquidity might struggle as said liquidity is withdrawn.

So what does this all point to for an investor? On the liquidity side of things, it hints at what we’ve already seen. The most liquidity-dependent and “flakiest” assets – “growth” stocks who currently have no profits and little more than a good story – have already fallen hard, and this concern is showing signs of spreading to the more dependable growth stocks (look at the Nasdaq’s tricky start to the year).

But how about the “what to buy” side? The good news is that while the US generally and the tech sector (growth stocks, basically) in particular is very expensive by historical standards, not everything falls into that basket.

Indeed, on the value side of the market, lots of other assets simply aren’t expensive at all. Research Affiliates reckons that value stocks in the US are priced for long-term real (as in, after inflation) returns of more than 6%, and as much as 10% “for the Japanese, European and emerging markets”.

In short, if you’re looking to position your portfolio for an environment which will see a lasting period of inflation, then you should be reducing your exposure to US growth stocks in particular, and building it up in areas outside the US.

If you’re looking for exposure to UK value stocks in particular, you should listen to MoneyWeek’s latest podcast, where the managers of Temple Bar investment trust (a value specialist) discuss their favourite stocks with Merryn.