Something Better Change
In my rebellious youth, one of my favourite songs was “Something Better Change” by the Stranglers. With everything that is going on in the world around us today, I can’t help but think that over the next decade many investors will be singing this song to their investment managers unless they have adapted their investment processes to cope with a world (and investment markets) that are very different to that we have known for circa 40 years.
In recent decades, the world has been a relatively “safe and happy” place. It has benefited from an expanding global workforce, increased globalisation, technological progress and benign politics. This has delivered gentle economic cycles and a progressive fall in interest rates and inflation which has dampened down volatility in investment markets and encouraged investors to buy long-duration investments as this has been the winning strategy.
The last year was a stark reminder that it has not always been this way and interest rates and inflation can rise violently at times. This has prompted my colleagues and me at Ravenscroft to thoroughly debate “What will the inflation environment, interest rates and economic cycle look like over the next decade? Will it rhyme with recent decades, or is it likely to be different?”
Worryingly, from discussions I have had with friends across the investment industry, many firms are focusing on the immediate minutiae (next inflation print, next GDP print and size of next interest rate rise) but are not discussing or considering whether the longer-term drivers of these measures are changing.
You may reasonably ask why is this important? Holding long-duration investments (long-dated bonds and growth-orientated equities such as technology stocks) has been the winning strategy in recent decades. This strategy has outperformed broad investment markets as due to the power of compounding, the beneficial effect of a falling discount rate is amplified the further out the cashflows underlying your investment are. 2022 was a harsh reminder that high and rising interest rates and inflation favour short-duration investments.
When we step back, look at the world around us and then consider some of the changes that appear to be afoot, the Ravenscroft discretionary investment management team thinks that a disinflationary pulse may pass through the world as the global economy normalises, but thereafter the structural rate of inflation is likely to be higher than we have become used to and may also be more volatile. Don’t panic, we don’t think 10% per annum inflation is the new norm, but we do think that in the decade ahead inflation could easily fluctuate within a range of 2% to 6%. If we are right, this environment will require more active investment management and will be kinder to investors who adapt their investment process to bring cash flows forward and build in inflation hedges.
Some of the drivers of higher-than-we-have-been-used-to inflation that we have actively discussed include:
The world is ageing, and workforces are shrinking. This slows growth and puts upward pressure on inflation via wages. If the labour force shrinks employers need to bid up for employees. An ageing world also increases government and personal spending on areas such as health, pensions and care.
The populace of the world is unhappy; we are witnessing extreme political outcomes around the globe which appear to be driven by inequality rising to dangerous levels. The reality is that since the Global Financial Crisis ended in 2009 those who had wealth/assets have become wealthier as the value of their assets has risen more than the rate of inflation. Those who did not/do not have wealth/assets are worse off as the pay rises they have received over the years have not kept pace with inflation. Governments around the world are trying to address the issue by introducing measures such as the minimum living wage which is inflationary in nature.
For decades the world has worked together as one collaborative trading block, pushing down the price of goods and services for the world by outsourcing to lower-cost countries. Courtesy of Covid and deteriorating geopolitics, this trend appears to have gone into reverse. The world seems to be splitting into two or more trading blocks and many countries are returning the manufacturing of essential or sensitive goods to their own country. The Russian invasion of Ukraine has also reminded governments that the world is not a safe place, prompting multiple commitments to inflationary defence spending.
The need to transition towards clean energy over the coming decades has clear inflationary implications due to the need to build out infrastructure and the low
If we are right, then central banks will spend most of their time over the next decade fighting to get inflation down to 2% rather than up to 2%. My personal view is they are likely to fail and ultimately give up on the arbitrary 2% inflation target as there is no academic justification or support for this Goldilocks number. A move away from the myopic focus on 2% inflation and a move towards more enlightened measurement, possibly an inflation band or an inflation target combined with other economic metrics, would be positive and support smoother economic cycles.
If you would like to discuss this article, the world we live in and its impact on investing, music choices, or indeed any other matter, then the team at Ravenscroft would be delighted to hear from you.
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