Ninety One: Going up? The value of 'Value' in a time of rising inflation expectations

Value equities tend to do well when prices rise. However, you don’t need to forecast inflation correctly for a well-constructed value allocation to be a useful addition to a portfolio.

Key points

• Inflation expectations are rising following the massive government spending in response to the pandemic
• Some investors are wondering whether to increase allocations to value equities, which tend to benefit from rising prices
• A well-constructed value allocation can offer diversification and inflation-protection – and you don’t need to forecast inflation correctly for it to be a useful portfolio addition

The continued absence of inflation has caused consternation in some investing circles. Indeed, one of the investment lessons of the last decade is that it is not sufficient for a fund manager to desire prices to rise for them to do so. In the Ninety One Value team, we are pretty agnostic on inflation – in the sense that we don’t know when it will occur. But this is not to say we are indifferent, because value stocks generally perform well with inflation. We know which side our bread is buttered.

The link between value investing and inflation has become a hot topic again. With the pandemic forcing nearly all governments to implement massive fiscal and monetary stimulus, some investors believe that the price stability of the last decade might be ending, leading them to wonder if they should shift some of their equity allocation to value. However, investing to benefit from inflation is tricky: if prices fail to rise, a portfolio constructed explicitly to benefit from them doing so will suffer.

To help us frame inflation expectations, we enlisted Ninety One’s Multi-Asset team (the requirements of brevity prevent us from reproducing here the entirety of their work on this topic, but we will happily direct interested readers to the team for a more exhaustive presentation). A key point our colleagues highlight is that, even for the pros, inflation is difficult to forecast. In a recent speech1, the European Central Bank’s Chief Economist Philip Lane showed a chart depicting the average contribution of various factors to the level of inflation across some 600 economic models. Other than ‘economic slack’, pretty much the only other large predictor of core inflation is the ‘unexplained’ factor, i.e., the error term. This suggests that the ECB does not have a good working model of inflation.

Daniel Tarullo, an ex-member of the US Federal Open Market Committee, recently came to a similar realisation: “After eight years at the Fed, my conclusion was that there is no well-elaborated empirically grounded theory that explains contemporary inflation dynamics in a way useful to real-time policymaking.”

This obviously has worrying implications for a central bank specifically mandated to target inflation (like the ECB). But it also drives home that any inflation forecast should bake in a large margin of error. Still, is there something useful we can say about future inflation? At a minimum, it would be nice to have some comfort whether we’re headed for deflation, low and stable inflation (say, 2%-ish), or high inflation (over 3%).

How money supply and other factors affect inflation

The traditionally most-accepted theory of inflation, as represented by Irving Fisher’s Quantity Theory of Money, held that an increase in the money supply always led to an increase in inflation. However, the last 10 years, and at least the last 20 in places like Japan, have exposed a big flaw in this premise: the US monetary base has increased 5.5x since January 2008, but the Consumer Price Index (CPI) is just 20% higher.

Our Multi-Asset team notes that the relationship between money supply and inflation has historically proved to be reliable, but only over long horizons (approaching 30 years). So perhaps there is still time for inflation to come through in response to the monetary expansion following the Global Financial Crisis. In the meantime, the money-supply effect appears to have been swamped by other factors, such as deleveraging by both public and private sectors, and globalisation. More precisely, our Multi-Asset colleagues attribute the disinflationary pressures of the last decade to what they call the “five Ds”:

1. Détente: a period of global peace and trade leading to abundance and prosperity. This is essentially the effect of globalisation.
2. Disruption: specifically technological innovation, which tends to lower costs.
3. Debt: the idea here is that borrowing drives spending, which leads to higher prices. The crisis of 2008/2009 was a credit bust, so the 10 years that followed were characterised by a deleveraging by both consumers and the banking system. The public sector had to step in and in doing so increased its own debt burden. It later adopted austerity measures and balanced budgets to try and bring public borrowing back under control. The combination of a deleveraging private sector and a restrained public sector dampened spending in both the US and Europe.
4. Demography: lengthening life expectancy and falling birth rates both push consumption down and savings up.
5. Disparities: the gap between rich and poor widened in most advanced economies after the Second World War. That has reduced consumption by the poor and increased saving by the rich.

Assessing price pressures today

If these factors, and others, can sap the inflationary properties of a ballooning money supply, then tracking their changes should be worthwhile. American economist Frederic Mishkin, for example, believed that an increase in money supply was not, by itself, enough to trigger higher prices. Rather, it needed policymaker support (i.e., fiscal expansion) without taxation, along with a specific low-unemployment objective. We are now getting this: while fiscal austerity was very much the mantra after the financial crisis of 2008/2009, the pandemic has forced governments to spend. This is a big change compared to the last 10 years.

At the same time, central banks (particularly the US Federal Reserve (Fed)) have begun to state publicly that they might be willing to tolerate “moderately” higher inflation than their 2% targets, to ensure that inflation expectations are properly anchored around that target and not lower. This is an attempt to use one of the circularities of inflation theory, which holds that a simple increase in inflation expectations might be enough to create higher actual inflation. The point is that, by telling the market that it will tolerate moderately higher inflation, the Fed is attempting to rectify the fact that inflation expectations have generally been too low over the past five years. It’s another significant change.

At the same time, we are witnessing at least some rolling back of globalisation. This ‘onshoring’ trend repatriates activities that had been moved to lower-cost locations. It’s hard to see this happening on a massive scale, but at the margin it raises producer costs and marks a shift in yet another heretofore deflationary factor.

Finally, we haven’t had a credit crunch this time. House prices are not falling (quite the opposite), a good number of households have saved substantial amounts during this pandemic, and the banking system is in good health. At the margin, all these factors were deflationary over the last decade and will not be deflationary this time around. Yet another change.

Of course, the above discussion guarantees nothing. There are still plenty of potentially deflationary forces that we have not discussed, namely that corporate leverage is high (particularly in the US), that asset prices are also high and therefore a crash would create a significant adverse wealth effect, and that demographics are still not supportive of rising prices. But on balance, our colleagues make the point that an inflationary scenario, especially in the US, is quite easy to construct. At the very least, perhaps it makes a deflationary outcome unlikely. The colour-coded table below, compiled by the Ninety One Investment Institute, summarises inflationary forces in each region, and suggests that the US is the best candidate for sustained reflation (green is positive for inflation, red is negative and orange is in between).

Source: Ninety One Investment Institute, 2021

It is worth pointing out that the market is already pricing in something like the above. To gauge inflation expectations, central banks look at the level of inflation predicted by inflation-linked government bond markets. For 2026-2031, the expectation is for average inflation of 2.1% in the US and 1.3% in Germany. Inflation expectations in the US therefore appear, in central bank lingo, ‘well-anchored’; i.e., the market expects some inflation, but not a lot of it. In Europe, by contrast, expectations are well below the ECB’s official 2% target.

The interest-rate swap market points to similar conclusions. The nominal interest rate that the US swap market is pricing in for the same period (2026-2031) is just 1.71%, resulting in a negative predicted real rate of about 0.4% (1.71% nominal rate minus 2.1% expected inflation). This indicates that the market is confident in central banks’ ability to maintain control of inflation, otherwise real rates should be well into positive territory (think of the aggressive rate hikes that Fed Chair Paul Volcker had to implement in the 1980s). For Europe, the expected nominal interest rate is 0%, implying a negative real rate close to 1.3% - a clear sign of scepticism over the ECB’s capacity to generate inflation. [Note on the UK: Unfortunately, assessing inflation expectations for the UK is not as straightforward due to the peculiarities of the index-linked Gilt market, in which relentless pension-fund demand has pushed prices up to a level where implied inflation expectations are no longer reliable - i.e., they look too high.]

The government-bond yield curve sends a similar message. It suggests that, for the next two years or so, interest rates in the US, Europe, the UK and Japan will be pretty much pegged at zero or below. Beyond that, the market is beginning to price in some interest-rate increases, in some markets more than others. This is what the chart below shows, with the 2yr/10yr US yield spread indicating a much greater propensity by the Fed to eventually raise US rates than the ECB in Europe, with the UK somewhere between the two.

Even so, the rate rises the market expects are not large. Once we remove the first two years of zero rates (the US 2yr note is yielding just 13 basis points at the moment), the period between years 2 and 10 only prices in US interest rates of 1.34% on average (Germany and the UK are much lower). Once again, it appears that if inflation is coming, the market is not worried about it.

Investment implications and positioning

Based on these assessments of inflation, we can perhaps draw some practical conclusions for investors, and consider the implications for portfolio positioning.

Inflation expectations:

• If the deflationary forces of the last decade are subsiding, then we can perhaps rule out a negative rate of inflation.
• Since the market has already priced in a degree of reflation, making a big explicit bet on inflation today requires a view that we are not only going to go back to a pre-pandemic level, but that we will significantly exceed it. This has implications for the type of inflation protection one chooses to take, as discussed further below.
• In our Value strategies, we normally just look for cheap stocks, regardless of whether they are generally expected to perform well in times of inflation. That said, among the stocks we like, some are generally perceived as inflation beneficiaries: banks and energy shares.

Inflation protection opportunities:

• The better reflationary prospects of the US economy, and the resulting steepness of its yield curve, mean that US banks should continue to have a profitability advantage (compounded by investment-banking superiority at the large money-centre banks) compared to their developed market peers in the EU, UK and Japan. This is therefore one of our preferred ways to get inflation protection, and unlike precious metals or other assets, US banks ‘carry’ positively to the tune of over 10% (via a combination of dividends and buybacks) on current share prices. Not many inflation-protected investments have such high positive carry and we see this as a key element of downside protection: the ability to still earn a respectable return if inflation does not show up.
• We also like oil & gas exposure (mostly through oil-services firms), where we believe that fundamentals are shaping up quite well for a tightly supplied market to emerge over the next decade. This fundamental positive backdrop has the additional perk of being inflation-proof.
• We think that most commodity prices, other than oil, already reflect a ‘reflated’ outlook. This is particularly true if we look at gold or even Bitcoin, the latter of which has surprisingly become an inflation-protecting asset in the view of some. It therefore does not appear to us that miners generally are particularly mispriced, unless inflation expectations really break to the upside.

Value portfolios and inflation risk:

• Finally, a conservatively-appraised value portfolio should be relatively immune to the increase in discount rates that would go hand-in-hand with higher inflation and higher rates. Conversely, equity sectors that have powered higher by riding the erosion of equity discount rates over the last two years might be vulnerable to a change in the macro picture. The following two charts, kindly provided by Bernstein, make the point that value is the only factor that is correlated positively to higher bond yields (the first chart) and that its negative correlation to the other equity factors is, in many cases, at an extreme (the second chart).

US 60 day rolling correlations vs. US treasury yields

Source: Bernstein, January 2021

Global equities 180 day rolling correlation

Source: Bernstein, January 2021

In summary, then, we would highlight that value stocks are cheap, uncorrelated with other equity factors and positively correlated to bond yields. If the world is heading for even a moderate sustained reflation, then value stocks should do well and provide some much-needed diversification. If inflation actually surprises to the upside, then we think a value portfolio is likely to be one of the only viable places to hide.

The value of investments, and any income generated from them, can fall as well as rise.

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