Equities in an inflationary environment

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April 2022
 

Walter Scott client investment manager George Dent looks back to previous periods of higher inflation, and how it has suited strategies like Long-Term Global Equity.

Equities have traditionally been “a good place to camp out” in an environment of higher inflation, argues Walter Scott client investment manager George Dent.

Dent observes that the last time inflation was at a meaningfully high level was in the 1980s. At the start of that decade, Pink Floyd’s “Another Brick in the Wall (Part II)” was at number one in the singles chart,1 he notes.

However, Dent says inflation is now verging on that level and is likely to remain high over the medium term due to a combination of factors. These include elevated energy and raw materials prices, higher interest rates, a tighter labor market, and supply-chain issues, particularly in certain Asian countries due to their zero-Covid approaches.

“Inflation over the medium term is something investors may well have to contend with,” says Dent. But he thinks those investing in equities, particularly quality growth companies, are well placed to ride out the bumps in the road created by higher prices.

For one thing, Dent says the pent-up demand in economies generated during the pandemic is a positive for equities, with any subsequent spending wave likely to benefit certain companies.

Moreover, he says a look at history shows that equities have held up well during periods of higher inflation.

Take the UK throughout the 1970s, for example. At that time, the UK Consumer Price Index (CPI) ran at an average of 13.1% a year and equities delivered marginally positive returns of 0.4% a year,2 says Dent. He adds while not necessarily being a great wealth creator, equities did a reasonable job during that decade of preserving wealth.

But in the 1980—a decade more representative of the current expected level of inflation—UK CPI averaged 7.6%, with equities delivering 11.7% over the period,3 notes Dent.

In recent years, record low rates have acted as a strong tailwind for equity prices and Dent says a cynical observer might ask what was happening with rates were during the 1970s and 1980s.

“In the 1970s, interest rates started at 8% and finished at 17%, so certainly not a tailwind for equities,” says Dent. “In the 1980s, rates started at 17% and dropped to around 14–15% at the end of the decade,4 so a bit of a tailwind, but not a huge one.”

Dent says during the Second World War years (1940–50) there was “reasonable inflation, at 6.1%, and a reasonable return on equities, at 6.3%,” but he adds, “it was not perfect.” During the First World War era (1910–20), there was an inflationary environment, at 9.7%, and while equities were down 8%, they performed better than UK gilts, at-10.8%, he says.

While choosing to use the UK as a case study, a similar argument can be made if looking at US data: as with the UK, America saw notable periods of inflation through the 1970s and 1980s, although not to the same degree as in the UK. During both periods, US equities posted positive real returns (averaging 1.1% and 7.6% over the 1970s and 1980s, respectively), although it’s perhaps interesting to note that, in contrast to the UK, in the 1980s US government and corporate bonds actually outperformed equities, perhaps reflecting the more dramatic drop in American interest rates over the period.

“Looking back at the last 100 years suggests equities are not going to be too bad a place to be if we are going into a more inflationary environment,” he concludes.

Walter Scott has long defined quality growth companies as highly profitable, with strong balance sheets and pricing power, and asset light. These are also attributes that should leave businesses well placed to weather a higher level of inflation.

Dent adds: “We don’t change our spots and do things the same way irrespective of whether we are going into an inflationary environment or otherwise, so these are all core attributes we look for, along with businesses that benefit from good structural tailwinds.

“Put those two things together and it leaves you with a skew toward areas like healthcare and technology and away from sectors like financials.”

In the healthcare space, Dent says Walter Scott invests in one of the global leaders in the treatment of diabetes. He says this company is highly profitable, which makes it resilient to inflationary pressures, and also because it does not have to rely on price-sensitive raw materials.

He also notes a Japanese automation business that makes sensors. Again, he says this business has been highly profitable with “great pricing power,” but more importantly, it should actively benefit from wage inflation. This is because the more wage inflation there is, generally, the greater the incentive for companies to automate their processes, he adds.

Dent also highlights a payroll processor in the Long-Term Global Equity strategy, which he says is a good way of benefiting from a rising rate environment without investing in banks, which may be often “highly leveraged and opaque.”

Payroll often becomes deeply entrenched in businesses and as such, it has sticky customers, Dent says. Payroll companies can also benefit in tandem with rising wages and in a higher interest rate environment.

He adds: “Our time is best spent not worrying about where markets are going over the next 12, 18, 24 months, but instead focusing on trying to find and align our clients with a select group of high-quality industry leading growth businesses.”

1 “List of UK Singles Chart number ones of the 1980s,” Wikipedia; accessed March 2022.

2 BNY Mellon IM using data from BoE Long-run inflation series and Barclays Gilt Study 2021. For UK CPI, average yearly UK Retail Price Index going back to 1900 is utilized.

3 Ibid.

4 Bank of England, Official Bank Rate History Data from 1694.

 

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