Higher inflation and the repricing of the cost of capital will make managing money much harder over the next few years, according to Troy Asset Management’s Sebastian Lyon and Charlotte Yonge.
As the investment environment potentially moves from a deflationary era to an inflationary era, it is a regime change that will put both asset managers and central bankers in a much more difficult position, Lyon warned.
He said: “My colleague James Harris says the solution for high prices is high prices – ultimately you get to a stage where demand abates and then prices fall back again.
“This time, it's a little bit different. It's very different to previous bouts of inflation. This bout of inflation feels higher, it feels stickier.”
Lyon said the Bank of England governor Andrew Bailey’s comments in February discouraging workers to ask for a big pay rise to help control inflation is one indication that central banks are losing control.
“He is essentially tacitly admitting that he's in a different era than the one that he was in before and he is admitting that if wages start going up then things are going to get a lot more difficult for central bankers, and they're going to have to tighten more down the line,” Lyon explained.
“Maybe we'll be sitting here in two years’ time, and everything will all settle down and we'll be back at 2% inflation and the economy will be growing at 2% and all will be well. But that's the rose-tinted view.”
This rose-tinted view is what markets at the end of 2021 were discounting before both stocks and bonds began to sell-off sharply, although stocks have since recovered most of the losses.
Performance of MSCI World Index & Bloomberg Aggregate Index year-to-date
Source: FE Analytics
Lyon said many thought inflation would be a temporary problem, but warned that the past two months – with issues such as the Russian invasion of Ukraine coming to the fore – have changed opinion.
“That means is running money is going to get harder. Generating a real return is going to get tougher. You're going to struggle because inflation is going to be higher, so your bar is higher, and your returns are probably going to be lower,” he said.
For co-manager Charlotte Yonge, this will come about from markets repricing the cost of capital, which is the most important thing that has occurred in capital markets since the outbreak of Covid.
As central banks start to step in to tame inflation with interest rate increases, it pushes up the cost of financing for both companies and individuals.
“Inflation feeds into the cost of capital and if that rises, then you really want to be modestly exposed to the equity market,” she said.
Although Yonge expects central banks to try and hike interest rates to levels that “look like they’ve got inflation under control”, she doesn’t expect nominal rates to reach levels that exceed today’s inflation figures which stand at 6.2% in the UK and 7.9% in the US.
She said: “I don't think they're going to be able to hike to anywhere near 6%. The reality is going to be that the Fed continues to be reactive.
“If markets respond really badly to rate hikes, if the economy responds really badly, there will be a point where those interest rates start to bite and I think the Fed backtracks before it gets to a point of extreme pain.”
The point of extreme pain is when interest rates are at such high levels that it hampers economic growth.
Additionally, since global indebtedness is so high relative to history it makes raising interest rates that much more difficult, Yonge added.
Indeed, global debt to GDP in developed markets is at levels similar to during World War Two, making it difficult to hike rates.
“If you look across sectors: households, corporates, and governments globally, debt to GDP is nearly 400%. So in order just to pay the interest on that debt – let’s just assume a generously low interest rate of 2% on that debt – you've got to grow nominal GDP 8% just to pay the interest cost. So the chance of you paying the capital back is nigh on impossible,” she said.
Therefore central banks need an environment of low interest rates relative to inflation and nominal GDP just to make the cost of servicing the debt manageable.
Yonge continued: “This environment of financial repression, whereby debt levels in real terms relative to the economy can come down, is what I think has to happen otherwise we will just be more and more sclerotic in our growth outlook.”
Although investors are right to be concerned about inflation, Yonge said too many are operating under the assumption that inflation is guaranteed.
“There's increasingly a sort of default to this inflationary environment,” she said. “We do have to recognise that some of these inflationary forces are countered by a backdrop which is one of increasing automation, increasing investment in technology, demographics and ageing.
“It's very, very hard to pinpoint whether we go into something that looks like 7 or 8% inflation on any sustained basis.”
Investors need to be open-minded that inflation could go either way and be invested in both assets that have inflation protection as well as companies that are well placed regardless of inflation or disinflation.