Long Term Investing during Inflation

Investing for the long term requires careful planning, discipline, and a clear vision of what you aim to achieve.

What’s New? In the midst of evolving economic dynamics, we’ve maintained a cautious approach to both bond acquisitions and similar fixed interest assets (lik e real estate ventures). This strategic stance is rooted in the prevailing low inflation and interest rate environment that has characterised recent years. And following the run-up in valuations, our prudence extended even to equities.

Low rates and leverage drove short-term returns: It is our view that historically high market prices of equities were buoyed by low interest rates and exceptionally high Returns on Equity (RoE) – on leveraged assets. RoE experienced a remarkable surge between 2007 and 2022 globally, but particularly in the United States, where it was largely driven by increased leverage and share buy-backs.

These returns are even more impressive given that nominal returns from 2007 to 2021 were nearly on par with real returns.

When adjusting for inflation, the high returns observed in 2022, which marked the peak of this timeframe, were significantly lower than historical averages.

Profitability declining? As interest rates rose, profitability, indicated by the spread between Return on Capital (RoC) and the cost of debt, experienced a decline. Lower valuations can be expected if rates stay high.

The S&P 500 index saw a substantial decline of nearly -20% in 2022. And last year was not only unfavourable for most stocks, but also for bonds.

A Family Office with a one-billion dollar investment portfolio would (at best) be shaken by a $200m paper loss, a fully-invested portfolio of US$5 billion, would see paper losses close to $1 billion… enough to churn any stomach and increase the perceived need for safety.

What are the options? The low deposit rates offered by Banks, makes cash holdings unattractive, and government bond rates are still mostly negative (in real terms).

While inflationary pressures are an increasingly well-known characteristic of the current market, it is crucial to analyse the underlying causes and duration of inflation.

Inflation arose from various factors, including excessive growth in money supply, stimulative fiscal policies, and structural shifts in the economy.

The first two causes have been thoroughly analysed.

The substantial growth in money supply, with the creation of 25% of all US dollars ever created occurring in the past two years, combined with fiscal stimulus, such as the US Federal Reserve’s $2.5 trillion private sector debt purchases at the highs, along with the cyclical recovery following the COVID-related economic shutdowns, were significant contributors to the sharp increase in inflation.

However, these factors were exacerbated by the liberalisation of the European gas market and unprecedented geopolitical reactions.

Energy pricing has changed:

The shift in European hydrocarbon gas pricing, now based on the virtual Dutch TTF (Title Transfer Facility), the primary gas pricing hub for Europe, from previous long-term gas contracts, and the geopolitical response to the Russian invasion of South-Eastern Ukraine, which involved imposing purchase restrictions on Russian gas, oil, and petroleum products, have fundamentally altered the industrial landscape.

Main losers: Countries that import energy and petroleum products, particularly emerging market economies in Africa and Asia, many of whom also import raw materials from Ukraine or Russia, have been significantly impacted by the prolonged regional conflict and the ensuing retaliatory policies.

A combination of higher imported inflation and increasing US dollar-denominated debt commitments (as a result of covid-related bailouts and higher energy costs) have led to a weakening of emerging market currencies. Many of these economies have resorted to increased domestic currency lending to ease Balance of Payments pressures.

Real returns across countries are greatly impacted by currency depreciations, and periods of high or hyperinflation can materially influence asset returns in Emerging Markets.

Real Annualized Returns (%) on Equities versus Bonds and Bills Internationally, 1900–2015

Additionally, OPEC, led by Saudi Arabia, a long-time economic partner of the USA, has aggressively reduced crude oil supplies.

Many economies already burdened by debt due to COVID stimulus policies are further strained by the artificially high energy markets imposed by “allies”.

Higher Costs!! Moreover, the trend of re-shoring production, which began under Barack Obama and gained momentum under Trump with the implementation of tariff barriers, is expected to accelerate further under Biden due to the US Inflation Reduction Act stimulus.

Similar measures and fiscal stimulus policies in Europe, are also increasing costs, and higher inflation expectations have driven wage expectations higher.

Inflationary pressures have spilled over into the services sector, and with lagging salary increases are anticipated to result in persistently high interest rates and potentially even further rate increases.

Are bonds Back?

Some investors are allocating aggressively to fixed interest rate securities, already anticipating a declining rates cycle. While peak inflation rates may have passed. Expectations are only slowly anticipating higher-for-longer inflation.

In a higher inflation environment, bonds are expected to structurally underperform a portfolio of companies earning Returns on Capital in line with (or above) long-term average industry returns.

Sources: Dimson–Marsh–Staunton (DMS) Dataset, CFA Institute Research Foundation (2016b, 2016c).

We believe, that although nominal bond yields have risen, negative real interest rates and the current geopolitical environment, characterised by escalating tensions between major consumer and supplier regions, coupled with depreciating currencies in emerging markets, does not present a risk-free hunting ground for Bond and EM investors.

Equities are King

Although returns in equities are also expected to be affected, in this market environment of heightened inflation, it is crucial to invest in businesses with pricing power that can effectively combat inflationary pressures.

Companies that possess the ability to adjust their prices in response to inflation can safeguard their profit margins and maintain a competitive investment edge.

Identifying and investing in such businesses represents a more prudent, lower-risk long-term strategy compared to investments in cash, or bonds with low expected real returns.

Great companies? But to find great companies that can sustain and compound earnings, are not easy. Of the US firms listed in 1900, more than 80% of their value was in industries that are today small or extinct; the UK figure is 65%.

Industry Weightings in the USA and UK, 1900 Compared with 2015

Note: For 1900, UK data are based on the top 100 companies and US data on the total market.

Sources: Dimson–Marsh–Staunton (DMS) Dataset (2002, 2015); FTSE Russell 2015.

Railroads, textiles, iron, coal, and steel all declined precipitously.

In turn, the pace of change accelerated. Companies (and countries) have to deal with more information, with quicker technological change, leading to unpredictable outcomes. Requiring more skills, more qualified people!

“Whether these changes are are for good or for ill must be our choice. Technology itself is neutral.” – Charles Handy – The Age of Unreason (1990)

Unlike the railway companies of old, to sustain performance, great companies need growth without the need for high, or additional, invested capital. Companies that can show the best growth with the lowest capex and financing needs.

Science of Hitting: In an email response to Jeff Raikes, then with Microsoft, Warren Buffett describes Ted Williams’s drawing of a batters box, with lots of little squares in it, all part of the strike zone… as outlined in his book called the Science of Hitting.

If he hit the baseball in his favourite spot, in his outlined favourite little square area, his batting average would be .400, reflecting what Williams thought he would hit if he only swung at pitches in those area, in his happy zone.

Buffett believed that he was not capable of assessing probabilities in favour of a 20-year run in Microsoft, in this technology, in this now famous analogy.

Great companies, that can sustain growth for the next 20, even 30 years, are not easily found, but when you do, your chances of successful investment improves dramatically (they are like fat pitches).

The next steps?

The history shows that over the long run, there was an increased reward for investing in stocks. Foreign exchange fluctuations (over the long-term) mostly responding to relative inflation, and the impact of exchange rate fluctuations on investment returns has been relatively modest.

We advise to carefully evaluate the profile of fixed-income and emerging markets investments during inflationary times and explore alternative strategies to mitigate potential losses.

This article isn’t personal advice or a recommendation to invest. All investments and any income they produce can fall as well as raise in value, so you could get back less than you invest. If you’re not sure an investment is right for you, ask for financial advice.

Phone: +44 (0)79 1751 7859

Email: sales@littlesquarecapital.com

Website: www.littlesquarecapital.com

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