Interest rates and inflation
You can’t turn a page or a news channel without hearing about (rising) interest rates and (rising) inflation.
It seems timely to review why and how central banks tackle rising inflation and ask some experts how individuals who can save and invest can do so to counter the effects of inflation.
At a very basic level, rising inflation means things cost more and the theory goes that if we stop people buying things, the costs will go down. So to keep us from buying things, interest rates are raised so that borrowing becomes more expensive. We cannot spend money that we cannot afford to borrow. And if we are already borrowing (mortgages are the biggest debt for most of us), it costs us more and so, again, saving and not spending becomes more important. In this way, it is hoped that the economy will slow down and help bring inflation down.
But things are never that simple. Chris Clothier, Chief Financial Officer and Portfolio Manager at CG Asset Management quotes the American economist Milton Friedman who famously said that: “Inflation is always and everywhere a monetary phenomenon”. Clothier says, “This description is far too narrow – inflation is multifaceted and very complex – but it underscores a fundamental truth that inflation occurs when there is too much money for too few goods. Raising interest rates – making money more expensive – dampens that demand and brings it back into balance with supply.
When interest rates are below the rate of inflation, people have every interest in borrowing and no interest in saving, says Rob Perrone, investment adviser at Orbis Investments. “It costs you to move money over time. Money loses purchasing power and loans become easier to repay, so why not borrow and spend? This incentive stimulates the demand for goods and services, which fuels inflation.
“By raising interest rates above the rate of inflation, people have an incentive to save instead of spend. You get paid to move money over time. Cash gains borrowing power and loans become more expensive, so it makes sense to pay down debt and reduce expenses. This blunts the demand for goods and services, which aims to control inflation.
But is it possible that rising interest rates won’t solve the problem? Maybe, yes since there can be different types of inflation.
So-called “supply-side inflation” or “cost inflation” is more resilient to interest rate adjustment. Clothier says the best example of this was the 1973 oil shock.
“Oil has played such a central role in the global economy, and its price has risen so much, that the associated inflation could not easily be contained by raising interest rates.
“Tightening monetary conditions through higher interest rates and controlling the availability of credit, applied with sufficient vigor, will generally be sufficient to control inflation. A bigger concern is whether the patient can stand the bitter medicine they are receiving. Extreme levels of global indebtedness, caused by decades of accommodative monetary policy, mean that the global economy is fragile and high interest rates risk leading to massive defaults and bankruptcies that will likely lead to a depression.
“Central bankers must attempt to chart a course between the two alternatives: runaway inflation or painful recession. It remains to be seen whether such a passage is navigable. Given high levels of initial inflation, on the one hand, and high leverage, on the other, the funnel of potential outcomes is very wide. We suspect that if policymakers are forced to choose between the two, they will opt for inflation because the alternative is likely to threaten the very integrity of the financial system.
Where to invest
Obviously where one invests very much depends on where we are in this navigation, which sectors of the economy, in the UK and globally, are most likely to help investors chart the right path to good returns.
Clothier says that during the 1970s, the best performing S&P 500 subsectors were energy and materials, with the worst performing consumer staples and technology.
“It should be noted that these last two have been the big winners for much of the last decade. Assets whose cash flows are explicitly linked to inflation should do well, including index-linked bonds, infrastructure and certain types of specialty goods.
Matthew Norris, Investment Advisor, Gravis Advisory, Advisor to the VT Gravis Digital Infrastructure Income Fund agrees on real estate and specifically on real estate investment trusts (REITs).
“The relationship between REIT returns, inflation and interest rates is complex,” Norris explains. “Simplistically, inflation increases rental income because rents tend to increase, in some cases contractually through inflation ties in leases, but rising interest rates increase the rate of actualization. Under these assumptions, generalist investors tend to view REITs as interest rate sensitive, with their knee-jerk reaction being to sell REITs.
“However, the strong digitalization megatrend contradicts this simplistic view. These specialist infrastructure assets should continue to generate decent rental growth while simultaneously benefiting from firm capitalization rates, as direct infrastructure investors maintain their appetite for high-quality assets.
“Rental income benefits from inflation-indexed rents or fixed-rate rent escalations – these assets produce growth income, not fixed income. Assets with real pricing power, such as e-commerce distribution centers, urban logistics centers and mobile communications towers, should provide good inflation protection. »
Mark Atkinson, head of marketing and investor relations at Alliance Trust, however, calls for caution on a sector-based approach. “We would say that it is generally not profitable in the long term to take a sector approach to investing, although in the short term it has certainly been beneficial to have exposure to commodities which tend to do well. perform in inflationary environments.”
However, says Atkinson, his stock pickers favor a stock-by-stock approach; “Because even companies in the right sectors to benefit from inflation could suffer if they are not well managed. Conversely, not all companies in sectors expected to suffer from an inflationary environment are doomed if they have good business models In any disruptive environment, there are always anomalies that good active stock pickers can exploit.
Alliance Trust stock pickers seek to assess the strength and positioning of companies against the market environment, to ensure that their long-term fundamentals are attractive and not eroded by interest rates and higher inflation.
“More defensive and quality businesses with larger moats protecting their business, customer loyalty, lower capital intensity and ability to weather price increases may overall prove more resilient to inflation. “, says Atkinson. “Like stocks that actually benefit from higher interest rates, like some financial companies. Businesses whose revenue is transaction-based, such as payment processors that benefit from transaction fees that represent a percentage of the increase in the price of goods and services, are also more isolated.
Examples of such stocks held by Alliance Trust include Visa, Mastercard, Fiserv Inc, Fleetcor Technologies, Block or Global Payments and in the energy sector where there has been strong momentum Exxon Mobil, Petrobras, Total Energies and BP.
Rob Perrone, investment adviser at Orbis Investments, says that in the energy sector, it’s not just upstream producers who stand to benefit.
“High gasoline prices may not persist indefinitely, but for some energy companies that doesn’t matter,” he says. “The United States and the EU have signed an agreement to increase exports of liquefied natural gas (LNG). A company we think thThis is good news for Kinder Morgan, the largest pipeline operator in the United States, because about half of the American gas destined for LNG export passes through its lines. More than 90% of Kinder Morgan’s earnings are insulated from fluctuations in gas prices, so we consider its nearly 6% dividend yield to be essentially inflation-protected. We think that looks attractive in an environment where US inflation-protected Treasuries are yielding just 0.1%.”
Box-out – Why central banks are raising rates to fight inflation
Central banks are banks for banks, where commercial banks keep their cash reserves. Central banks set the interest rate they pay on these reserves. If the central bank raises interest rates from 0% to 2%, it ripples through the banking system throughout the economy. If banks can get 2% by leaving money at the central bank overnight, they will charge more interest to lend for longer periods or to riskier borrowers. This drives up bond yields and lending rates for households and businesses. Since borrowing is more difficult, people can reduce their expenses and pay off their debts. This affects the demand for goods and services, which should contain inflation.
See also: The link between interest rates and inflation