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Our views 07 March 2022

JP’s Journal: Inflation: high, and rising

5 min read

Let’s be honest: I have never heard of Natalie Jaresko. But I read her article in the Financial Times (FT) last Thursday and it really brought home to me what ESG has become for many companies: Happy to put out great sounding platitudes but afraid to take hard decisions. Again, in the spirit of openness, the same can be said of some asset managers.

Anyway, the gist of the article, is that upholding democracy and protecting freedoms should be at the centre of any approach to ESG investing. And this surely has to be right. ESG is not about box ticking – although unfortunately this seems to be the path of least resistance. It is about assessing complicated non-financial risks with may impact upon long-term returns. Without a rules-based system of law it is impossible to evaluate these risks. Now, it is not realistic to say that all countries should follow a particular path such as western style democracy; this may be an aspiration but does not align to the world we live in. But there has to be a line set for norms of behaviour below which no amount of financial return can compensate. And the reason is simple: investors’ long-term returns are best served by respect for rights – take this away and we don’t have a lot left to make long-term judgments.

So, let’s see how companies respond to the present crisis. Let’s see how their rhetoric aligns with their actions. At that point we can judge the ‘ESG-washers’ from the real McCoys.

Inflation is the topic I cannot get away from this week. With oil at $130 a barrel and gas at 600p per therm, the prospect of inflation around 10% in the UK is looming. Electricity, gas, and other fuels have a 4% weighting in the Consumer Price Index (CPI); add in transport costs and you can see that the rise in oil and gas prices will be adding significantly more than 1% to the level assumed pre-crisis. Whilst the UK is relatively self-sufficient in wheat the impact of the crisis on global food prices will also be felt. And don’t forget how higher staple food prices tend to be a precursor of internal unrest in many parts of the world.

Against this background risk assets underperformed. This was most noticeable in equities, with large falls in the latter part of the week. Government markets benefitted from a safe haven bid with 10-year US treasuries moving to 1.7%; the euro area saw German equivalent yields going negative again whilst in the UK 10-year yields approached 1.3%, quite a bit away from the near 1.6% seen a month ago. The big impact was on implied inflation; in the US breakeven rates at 20 years moved materially higher, ending the week at 3.2%. The UK rate also moved higher, but by a lesser amount. Still, we are seeing 10-year implied rates near 4.5%, a long way from the latest Bank of England policy remit.

Central banks are in a quandary. Putting rates up won’t stop energy inflation, but not doing anything sends a message of complacency. So, I think rates go up but some of the more aggressive tightening suggestions will be put on the backburner. When we look at what markets are pricing, we can see that one rate hike has been taken out of UK expectations in recent weeks – but that still leaves markets focusing on five hikes of 25bps over the next 12 months. One thing is clear: global growth rate forecasts are going to come down. This will put more pressure on risk assets and, in a relative sense, favours the US over Europe. The saving grace here is real yields. As I have written before, with real yields low or negative across the world, credit and equities will remain supported, even as the outlook gets choppier.

One thing that has happened in recent weeks is that the Ukrainian crisis has pushed Covid down the news items. And I think this is being reflected in peoples’ actions. Certainly, in my area shops were busier this weekend and there was visibly more traffic. This may be due to a sense of spring but I think people are starting to move on from a Covid mindset. Our office last week had a vibrancy that I had sorely missed during lockdowns. As well as getting back to a sense of normality this has to be great from a mental health viewpoint.

For those interested I am still cycling to work. So, the tube strikes last week did not impact me – just a few more cyclists out. One thing is certain – I won’t be going back to a daily commute on tube or train. I will vary depending on commitments and inclination. This is bad news for Transport for London. It is facing a real challenge: how to attract customers back, how to offer greater flexibility and how to modernise; I don’t envy this challenge. And, in the world of finance, this is reflected in credit spreads., now around 1.4% for 10-year bonds. Not exactly a problem, but a far cry from the sub 0.5% levels seen in recent years. More generally, credit spreads widened last week with the sterling non-gilt premium moving to 126bps and high yield moving above 500bps.

I don’t usually use my Journal to plug Royal London – better to let readers make their own decisions; there is enough propaganda around nowadays. But the contribution made by my employer to the Red Cross, in the wake of the humanitarian disaster unfolding, was a great response. Thanks.

Past performance is not a reliable indicator of future results. The value of investments and any income from them may go down as well as up and is not guaranteed. Investors may not get back the amount invested. Portfolio characteristics and holdings are subject to change without notice. The views expressed are those of the author at the date of publication unless otherwise indicated, which are subject to change, and is not investment advice.