We have been broadly of the view that the global economy is transitioning from a long period of falling inflation and interest rates to one of gradually rising inflation and interest rates. While we do not think it likely that we will see this shift occurring rapidly, we do think that the disinflationary forces of the past few decades are now fading or even reversing.
It is worth reminding ourselves the reasons given for the long deflationary period. First, was central bank independence, concentrating on reducing inflation, which is arguably no longer the case. Another is globalisation, particularly the rise of China which, given recent talk of trade wars and the growth of wages in China, seems also to be fading. A further one is the global savings glut, as the baby boom generation and the emerging Chinese market drove yields down. Again this appears to be passing as both cohorts age and move towards spending those savings.
Therefore, we think the balance of probabilities is that inflation and bond yields drift higher over the coming years, subject to the near term effects of economic cycles. In such an environment we think some of the basic presumptions that investors have come to believe will be challenged over the coming years: what has been seen as highly valued will become less so and assets that were previously ignored may come back into favour.
Clearly, the huge preference that investors, both retail and institutional, have developed for fixed income is likely to fade, albeit gradually. Rising bond yields mean that capital losses will become the norm, whereas investors have become accustomed to earning both an income and a capital gain on their fixed income portfolios. Many years ago, gilts were known as certificates of capital confiscation during the period of high inflation. In that era, capital was eroded by rising yields and further eroded in real terms by inflation. Rising bond yields make decisions around credit selection and duration much harder, as any bond’s yield must be sufficient to offset the potential capital loss from rising rates.
In equities, the period of falling inflation and rates has led investors to prefer asset light, goodwill-driven businesses, particularly those capable of supporting debt, such as mature pharmaceutical businesses and fast moving consumer goods businesses. These companies built their assets (brands or new drugs) with revenue investment (such as research and development or advertising spend) whilst adding further value through taking on debt at falling costs. In a rising inflation environment, the cost of maintaining those assets will be rising, while the debt will provide a further headwind to growth.
In contrast, those businesses with high levels of fixed assets have been out of favour for many years, yet in the future the replacement cost of those assets will be rising and with a shortage of savings, capital to build new steel mills, pipelines or railroads, for example, will be scarce. It is our belief that the value of existing capital invested will be appreciating as replacement cost rises, and the global savings glut reverses. However, in many cases, this type of business often has substantial levels of existing debt. So, identifying those businesses that have scarce and attractive physical assets but low debt levels will be the key to benefiting from this new emerging trend, and this has been a key focus of our recent investing activity.
We have been building positions in US pipelines, airports and railroads globally to complement our existing positions in paper, steel and other hard asset businesses in recent months. These companies appear lowly valued but should benefit both from a strong economy in the short term and, more importantly, position the fund to be defensive against potentially rising inflation and interest rates in the long term.
Past performance is not a guide to future returns.
The value of stock market investments will fluctuate and investors may not get back the original amount invested.
Forecasts are not reliable indicators of future performance.
For funds investing globally, currency exchange rate fluctuations may have a positive or negative impact on the value of your investment.
Changes in interest rates will affect the value of, and the interest earned from bonds held by the fund. When interest rates rise, the capital value of the fund is likely to fall and vice versa.
For Investment Professionals only. Not for onward distribution. No other persons should rely on any information contained within this document.
Source for information: Miton as at 08/08/2018 unless otherwise stated.
The views expressed are those of the fund manager at the time of writing and are subject to change without notice. They are not necessarily the views of Miton and do not constitute investment advice.
Miton has used all reasonable efforts to ensure the accuracy of the information contained in the communication, however some information and statistical data has been obtained from external sources. Whilst Miton believes these sources to be reliable, Miton cannot guarantee the reliability, completeness or accuracy of the content or provide a warrantee.
Issued by Miton, a trading name of Miton Asset Management Limited the Investment Manager of the Fund which is authorised and regulated by the Financial Conduct Authority and is registered in England No. 1949322 with its registered office at 6th Floor, Paternoster House, 65 St Paul’s Churchyard, London, EC4M 8AB.