Charlotte Yonge: two ways to protect your money from inflation

published 25 March 2022

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Merryn Somerset Webb: Hello, and welcome the MoneyWeek Magazine Podcast. I am Merryn Somerset Webb, editor-in-chief of the magazine, and with me today is Charlotte Yonge. Now, Charlotte is involved in the management of various funds that I think some of you, a lot of you, will have holdings in. She is the fund manager of the Troy Ethical Fund, and she is the assistant fund manager on the Trojan Fund and on Personal Assets Trust, which I think an awful lot of you will hold because it is in the MoneyWeek Investment Trust Portfolio. And may I say thank God for it.

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It’s going to go away. We don’t need to prepare for inflation. We don’t need to invest with an eye to inflation because it’s short term, and we can look through it. Now, one of the ways, in which Troy has been different, and the where the asset allocation of the Trojan Fund and of personal assets has been different, is that you have been preparing for a long-term inflationary environment for some time now, right. So, tell us about that. Tell us why you thought this inflation was coming and where you think it’s going from here.

Charlotte: Yes, it’s a great question, and it is something that we’ve seen as a risk for a while, but I think the risks have just intensified. So, going back in time to when Personal Assets Trust and the Trojan Fund first bought index-linked bonds, really in a big way after the financial crisis, there was a huge explosion in money supply then, but what didn’t happen, and what we’re seeing now is a huge fiscal support in conjunction with the monetary stimulus that QE and central banks provided. So, what we had back then was asset price inflation. None of it really fed into the real economy.

Charlotte: Exactly, so there was no incentive, rather the opposite, in terms of regulation, for the banks to lend, but at the same time, there was also no transmission mechanism, so basically a feed through from, OK, we’ve created this money, is it going to end up in the pockets of someone who might spend it? There was absolutely no link from that being on the balance sheet of a bank to actually being in someone’s pocket.

Merryn: OK. So, now we have a situation where, even though the direct transfers into people’s pockets have ended… Certainly furlough has ended and all those various schemes here ended in the US where people were simply paid to stay at home and not work, and their expenses fell, but their income more or less stayed the same. Well, amazingly, in many cases, particularly in the US, people’s incomes went up during the pandemic.

Charlotte: Those transfer payments are over, but they’re still sitting on a balance sheet of households. So, if you look at what household savings have done on a cumulative basis since early 2020, they’ve now racked up to around 20% of what the average US household spent in 2019. So, there’s all this firepower just sitting there, ready to be spent. And we’ve gone back to a normal reopened world. The US is only just starting, so there’s a huge amount of pent-up demand. There’s now somewhere for that to be unleashed, and we’re seeing that, we’re hearing that from companies.

At the same time, you’ve got wage inflation. So, incomes are also increasing, and it’s really how that counteracts what is obviously a higher cost of living, due to energy prices. So, it’s going to be really important what wage inflation does. And I think, again, this is different to the financial crisis, it’s very clear there’s a political mandate, a real political support for, particularly, lower-income demographics to earn more.

Merryn: That’s interesting, and we keep hearing, in the UK in particular, that it’s not possible for there to be another wage price spiral like there was in the 70s because labour doesn’t have power anymore because the unions aren’t powerful. And they used to have these incredibly powerful unions. They could make these huge pay demands for their members, and very often, they would come through, and that’s what drove that wage price spiral in the 1970s.

But looking at it now, and particularly, as you say, with governments behind the idea that wages must rise, it slightly seems to me that it’s the other way around, that in fact, it’s inflation that will drive the power of labour, in that, as inflation comes through, more people join unions, more people want to organise. And so the organisation of labour, it’s perfectly easy for it to come after the inflation, rather than to be the initial cause of the inflation, particularly if the government is supporting that.

Charlotte: I think that’s right, and I think also, you saw that in the 70s. Even though union membership was just structurally higher back then, the wage inflation actually followed the higher cost of living. I think what’s quite important is that we’ve also seen a lot of people leave the workforce, as I know you’ve written about it. And that’s given a lot of bargaining power to labour, particularly in the US. A lot of baby boomers have retired early.

You’ve seen a lot of people just say, actually, I want to set up my own business, and companies are really struggling to hire. So, there’s that, and then, I think, exactly what you’ve just said, the longer that this current inflation, whether it’s transitory or not, the longer that it persists, the more likely behaviours are to change. So, behaviours of consumers, so actually thinking, oh, my money’s going to be worth less in a year, I’ll spend it now, but also, really importantly, the psychology of companies, owners of companies and how they respond by paying their labourers.

And I think the longer that you see this last, and this is why Ukraine is really interesting and really important, because that has clearly put peak inflation we might have seen in February, but it’s really unlikely now that that’s the peak because of all the energy and food implications on the back of the crisis in Ukraine and Russia. So, I think that will change behaviours, and that can be self-perpetuating.

Merryn: Yes, we’ll come back to that supply issue in a tick. I just wanted to ask you, there is now a view that I keep reading, that a lot of those people who’ve left the workforce in the US and in the UK will come back, because when they left, stock markets were at a high, they felt very wealthy, and they also believed that inflation would continue to be low. Now, there’s been quite a significant change, whereas markets have recovered significantly, but nonetheless, that volatility is going to make people begin to feel a bit uneasy.

Charlotte: I think that’s definitely right. It might take time. I think what the stock market does will be quite instrumental in how long it takes. I think, in the UK, after financial crisis, we saw a lot of people come back to work, so a lot of baby boomers retiring early and then coming back. And that will be an important driver this time as well. So, we are, and just on our inflation outlook at Personal Assets Trust, we are pretty openminded as to how this pans out.

Now, we do think the risk of inflation is a lot higher than it’s been, and we need to protect against that risk, given the mandate is real capital preservation. But it might not be these sort of high levels that people are talking about in terms of the 1970s. it seems unlikely to be. It’s just likely that it’s going to be higher in the past. And where exactly that lands is going to be a function of all of these different forces coming together, and we’re still in the melting pot, so it’s very hard to see.

Merryn: Yes, well, let’s go back to the supply side, in that, maybe one thing that we might have expected, even without the War in Ukraine, even without that, one of the things we might have expected would mean some kind of energy supply crunch, well, fossil fuel supply crunch, should we say, because we’ve underinvested so significantly there over the last decade or so. But the thing that we didn’t necessarily expect was the sharp rise in food prices, and that’s something that’s going to drive higher inflation than we might have expected.

Charlotte: That’s right, and I think it’s most important, actually, for emerging markets who, for example, Sub-Saharan African countries, 40% of their inflation basket is food, and they import a lot of that from Ukraine, from Europe. I think, in terms of the impact of that in the US, you look at food and energy, it’s a much smaller component of the inflation basket, and it’s a much smaller component of the basket than it was in the 70s as well.

So, it definitely is going to feed in, but I think the people who are going to be really, really hurt are in emerging markets. And that’s important because that clearly has an impact on demand and sentiment globally, and so, wide-ranging ramifications a bit like the Arab Spring. So, that’s the sort of area where I think the macro result is clearest, and we should just see, in the US. And the UK and Europe is clearly more impacted than the US.

Merryn: Yes. So, that’s where, certainly in the emerging markets, we might need to start thinking about the possibility of more geopolitical instability. Now, the other thing that might keep driving inflation, particularly through the supply chain, is zero Covid policy in China, right. So, we’ve been talking about this at MoneyWeek for a while, that as long as there are zero Covid policies across most of China, we’re always going to have a lot of risk inside the supply chain because these groaning shutdowns just keep causing more and more problems.

Charlotte: Definitely, and we look at US inflation, just because that’s where we find the cheapest inflation protection, but the component parts are very similar to the UK. Of the excess inflation that you’ve had since 2019 in the US, you see 40% of that excess has come from new and used vehicles prices, mainly used vehicles. And that’s a huge amount, and as you said, that really comes back to semiconductors, the supply chain, a lot of which is based in Asia.

But in fact, we could look back and say, do you know what, the level of inflation over the last couple of decades has been absolutely nothing to do with central bank policy and everything to do with globalisation with the opening up of global labour market, China entering and Eastern Europe opening up, etc. That has kept inflation low, globalisation, effectively. It’s been nothing to do with central banks, and now here we are in this reversal of that situation where supply chains from China are incredibly sticky, and things are getting difficult, and labour is tight, etc.

Charlotte: Yes, I do think people bestow a little bit too much faith in the central banks’ ability to do something, particularly when it comes to supply. So, historically, they can have an impact on demand, and I think they will continue to be able to have some impact there, so raising interest rates, effectively, you reduce demand for borrowing. You disincentivise that, and ultimately, particularly in the US and the UK actually, which has a higher rate of variable mortgages, increasing that interest rate does hurt the consumer, and it does have an impact on demand.

Merryn: So, if we can agree, well, let’s agree, for the sake of argument, that inflation is going to continue at a higher rate than most of us experienced for some time, for many years to come, how do we protect ourselves? This is what you do when you’re funds, right, is, you’re working to maintain our long-term purchasing power to preserve our capital. That’s not easy in a time of inflation, so what’s the main protection inside the fund?

Charlotte: Yes, so in Personal Assets Trust, we have, really, two asset classes that are doing that, and the first is index-linked bonds. I mentioned, we find the best value in US index-linked. They’re currently still, and this has changed marginally in the last few weeks, but mainly at the short end, so in terms of the next two to three years of inflation expectations, that’s started to price in something a bit more akin to what we’re experiencing.

But if you go further out, we look at this five-year forward, which is basically saying, from 2027 to 2032, what is the market expecting, in terms of inflation? And that number, as priced by the US bond market, is below 2.4%, OK. So, that’s relative to last month’s inflation of just under 8%. So, we really don’t think it’s pricing in any sustained inflation overshoot, and I think, for that reason, you are getting pretty good value inflation protection. There’s certainly no premium for the uncertainty, in terms of inflation and the volatility.

And I think we can definitely agree on the fact, A, it’s probably going to be higher and, B, it’s much less certain than it was over the past 20 years. So, I think that inflation linked is probably the first way that you would want to protect. The most important thing with that, thought, as well, to realise is they’re not just linked to inflation expectations or what we call break-evens, but inflation-linked bonds also have a nominal yield component, so what, actually, bond yields in a conventional market are doing.

And it is our expectation, and this comes back to central bankers, that they cannot afford to raise interest rates to any great extent above zero. And clearly, they’re trying to do that now, and a lot of that’s priced in. So, our view is actually that that nominal yield component also stays low. So, effectively, real yields, the yield after inflation, goes more and more negative, as ultimately, these inflation expectations and inflation reality starts to get priced in.

So, I think, watch this space in terms of where real yields go. In the UK, they’ve gone a lot lower than in the US, so you could get some really nice capital gains if you saw that divergence reconnect again. The second way that we’re protecting is by owning gold in the portfolio. And gold really is this currency. People think of it as a commodity, but it’s really a currency that central bankers can’t print. It’s finite in its supply. It’s been around, unlike some other alternatives, for millennia, so it really is well-established as this alternative store of value.

The way that we… And just briefly on the Ethical Fund, so we are clear about what ethical means, ethical is, effectively, client-led for us, so we’re not being the moral arbiters about what is excluded or included in this fund. We’ve, effectively, launched it in response to client demand, so clients saying to us, we want access to the same types of returns that you deliver for the Trojan Fund for personal assets, but without exposure to certain things.

And in particular, that applies to equities, but also with gold, we’ve, effectively, put in a binary screen, whereby we maximise the gold that has been responsibly sourced. And the way that we could ascertain that is by auditing the gold, so auditing the physical bars that underpin the ETCs, the exchange traded commodities. Now, we can’t do that with a royalty-and-stream company because their operations are far too far-flung and diverse for us to be actually able to audit that gold.

So, we just own physically backed ETCs. But it’s a great question. We’re actually engaging as well on those responsible standards to make sure that they are even more stringent, in particular on the environmental side of things, because I think that’s an area where there’s a huge amount of work to do for refiners to actually become renewable and carbon-neutral. But I think that’s the direction we’re going in.

Merryn: Now, you said that the Ethical Fund is very client-led and about what clients consider to be ethical and what they don’t consider to be ethical. And obviously, there is a difference between ethical and sustainable and ESG, etc, but let’s leave aside all that technicality for the moment. Is what clients are asking for changing? One of the interesting things that’s happened over the last few months is we’ve seen a change in view about whether, for example, fossil fuel investments can be considered to be ESG investments and whether defence stocks, for example, can be considered to be ESG investments.

And maybe six weeks ago, everyone would have said defence stocks, absolutely not. I exclude those from any idea of what is ethical or not, but now, of course, people are beginning to say, well, hang on a tick here, do defence stocks serve a social function, and could they therefore be considered to be ESG compliant in various ways? So, I suppose, the question is, just given everything that has changed over the last few months, are you feeling from your clients any change in how they might define ethical?

Charlotte: Not particularly, in terms of the types of sectors. I think what we’ve definitely noticed, and this doesn’t really pertain to whether they’d be invested in personal assets or in the Ethical Fund, we’ve found, and this is where I would draw a bit of a distinction, they’re much more interested in what we’re doing on ESG. So, the ethical screens are what they are. They’re binary, they’re quantitative, they happen at the start of the process.

The ESG bit is actually working out, OK, well, what are the big issues for this company? Do they acknowledge them, and are they doing enough about them? And that is the area where clients want to see more and more of what we are already doing, but we’re doing more and more, so for example, engaging with businesses that, frankly, don’t have sufficiently stringent net zero targets or perhaps aren’t finding a solution to the plastics problem.

Those types of areas are the things that clients are most interested in, and I would say, coming back to your point on different types of sectors, there’s no white company, and there’s no black company. There’s just shades of grey across the spectrum, and what it’s really about is companies getting it and getting their responsibility to, OK, well, this is a big problem for me. I need to provide a bit of leadership on the solution. I need to invest behind it.

Merryn: OK, great. Really interesting, thank you. Now, let’s move on to the area I think people are particularly interested in, which is your stock selection. So, I know that for a while now, the general view at Troy has been that markets as a whole are overvalued, that there’s been a lot of extreme valuation, particularly in the US. And clearly, that’s not the way you like to invest, so how are you feeling about markets, equity markets in general now? And what type of stocks are you currently invested in?

Charlotte: So, I think equity markets generally, we feel nervous, and that’s reflected in our equity allocation. We have a mid-30s allocation to equity. I would just remind investors in personal assets trusts who have seen the journey, we were as low as 30%, going into Covid, but then we really took advantage of lower valuations and went up to the mid-40s. And it would have gone right into the 50s, had we not taken profits and, frankly, reduced that risk, because the issue that we see now is that stocks have run a really, really long way since Covid.

And that’s notwithstanding the recent selloff. Frankly, if you look at our portfolio, the equities year to date have fallen only 4%. There hasn’t been a massive reset, in terms of valuations. Valuations in our portfolio are fair to a little bit higher than we’d like, particularly for those stocks where we have lower exposures. And if you see a, sort of, 1% holding in the fund, it’s because we really like the business, we just want to own more of it at a better valuation.

So, we are nervous, and I think the reason that stocks have done so well is also the reason that they could come crashing back down. Effectively, the cost of capital went right down to zero during Covid, and that clearly, as you mentioned, benefitted a lot of meme stocks, a lot of companies without any profits. It saw a lot of growth stocks go to the moon, and the risk is that that discount rate reverses, and the cost of capital actually starts to reflect the fact that, OK, we’re seeing some inflation here, and the world is a hugely uncertain place, so I want a bit of an equity risk premium for the stocks that I hold.

And we are seeing that start to topple a few of the highest-flying Tesla’s of the world, but actually, the kinds of stocks that we would invest in, the ones with really, really strong profits that have grown those profits for years and years and are well established, the prices haven’t come down very much. So, we’re certainly on the front to add, but we’re not yet at a level where we’re really excited to be able to add to equities.

Charlotte: There are some changes. So, in the last couple of years/three years, we’ve added Alphabet. That’s in the top ten now. It wasn’t until 2019. The same with a healthcare company, Medtronic. So, we do find new ideas, but as you say, we’re very, very discerning, so we’re not changing the portfolio around every month, every year. We’re just looking for those really exceptional businesses, frankly. They have to hit a very, very high bar, and then once they do, they have to be at a valuation where we think we’re being paid to take the risk.

Charlotte: Yes, definitely. There are lots of reasons that people spin a very bearish narrative on the payments networks from time to time, and it happens periodically with, for example, when PayPal became very, very successful around five years ago. Everyone was worried that the payments networks were getting disrupted, and ultimately, they were going to lose out. It was a zero sum game. The reality with PayPal, and this is the same with lots of the fintech disruption that is being seen today, is that PayPal can’t exist without the card networks.

And the same applies today, so the same applies to the buy now, pay later disruptors. And that was a big narrative that actually, after all the pain of Covid, which clearly impacts card networks because they have lots of cross-border travel expenditure that came back down, it’s now returning with gusto, they actually also then saw this sort of bearish headwind of, oh, all the fintech companies that, actually, Visa’s partnering with, are going to eat into your competitive moat and destroy your business.

So, for us, they’re not taking an extreme political stance. This is a company that is choosing to take a neutral position, and, frankly, not penalise civilians in that country. I think the most important thing with Nestlé is, particularly when it comes to, perhaps not the investor community, but more the consumer or the retail community, sometimes, is that people remember the Nestlé of 30 years ago, which is a really different business from the company today.

The company today is incredibly progressive, particularly when it comes to environmental issues. They’ve invested a huge amount behind recycled plastics, for example. They’ve invested more than any other company in saying we’re going to buy food-grade recycled plastic, so the suppliers, you’d better get going, because we’re here as the largest food company to actually drive that change. And they’ve created a new market by making that commitment upfront.

So, I think the current management team don’t get enough credit for a lot of what they’re doing. And perhaps that’s the case, and we do speak with them, and we engage with the business on biodiversity as well, for example, where again, they are industry-leading, in terms of actually going, not just to deforestation-free, but actually going further and saying we’re going to help, in terms of reforestation.

Charlotte: Yes, so the good thing about Nestlé is, a lot of their products are more premium. So, you think about the Nespresso brand, a lot of their pet food brands, people are prepared to pay more for these still very low-ticket items, but small luxuries, which, in the past, actually, Nestlé had a lot fewer premium products in the portfolio, and with those, it is harder to get that price increase. But where they stand today, they are doing well to offset a lot of the inflation. It doesn’t mean that they’re necessarily going to profit from it.

They are just going to be able to pass most of it on. it’s still a challenge. It’s a challenge for all these consumer companies, but it’s something that they’re really, really well-situated to grapple with, and they’ve got that diversification, in terms of geography, in terms of end-market consumer, that ultimately, nothing will be likely to really, really hurt, in terms of, actually, whether it’s commodity price inflation, or whether it’s, for example, the emerging market impact of these higher food prices.

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