The dangers of sticky inflation

Paulina Duran from The Australian recently spoke with Talaria Co-CIO Hugh Selby-Smith on a variety of topics relating in particular to the dangers of high persistent inflation and the lagged impact of interest rates rises on global economies.

See the article below.

Don’t underestimate the dangers caused by sticky inflation, say experts

If you are on the fence about where inflation and interest rates will go from here and what it means for investments, you are not alone. Investors of all types across the globe are trying to get their heads around that same issue.

Many – from the nation’s largest superannuation funds to the smallest of retail investors – are positioning defensively and parking money in cash and in bonds, given they are paying the highest yields in more than a decade.

Clearly, many others have instead jumped on the equities bandwagon, with global shares as measured by MSCI’s World index up 17 per cent since the beginning of the year.

The share allocations have ­occurred even as central banks around the world have lifted interest rates at the fastest pace in a generation – many expect this to hit company earnings.

However, a Bank of America global fund manager survey shows investor sentiment remains at near record lows, with most (60 per cent) expecting weaker global growth, the allocation to stocks sit at a seven-month high.

The vast majority (78 per cent) expects lower inflation in the next 12 months.

Morgan Stanley chief investment officer Mike Wilson agrees, and says inflation is likely to “come down faster than people expect”. He says: “We’ve just been surprised at how far multiples have gone on this inflation impulse coming down.” Earnings multiples on US stocks have risen from 15.5 times forward earnings in October last year to 19.5 times now. At the world level, multiples sit at about 16.6 times, with Australia’s at 15, according to BofA Securities.

In addition to the hype around artificial intelligence that has boosted the prices of technology-related stocks, government spending has also been key in preventing company earnings from plummeting.

But for equity prices to keep going, either those valuations have to keep rising, or earnings expectations have to be upgraded at a time when higher interest rates are meant to be weakening economic growth.

Recent data showing lower than expected June inflation in countries such as the US and UK also prompted market bulls to bid into the numbers, as they expect this increases the chances of central banks moving to a more ­accommodative stance, which is a positive for equities.

But the famously bearish Wilson disagrees, saying: “Inflation coming down is good for multiples. (But) at this point I would have thought that we’d have more evidence already or that the market would be worried about the damaging effects of disinflation turning into deflation.”

He says consumer goods discounting is getting “pretty heavy” as companies try to remove excess inventory and “we think that’s the next phase. It’s going to be really hard for me to get bullish on earnings given that dynamic.”

Hugh Selby-Smith, the co-chief investment officer of Australian bottom-up value investor Talaria Capital, is similarly bearish on the market, expecting the impact of higher rates to hit earnings in coming months.

But he disagrees with the widespread view on the direction of ­inflation. He says that, besides pervasive fiscal spending, three other long-term trends could mean inflation will remain elevated for longer.

These include a global labour shortage, the huge investment needed to decarbonise economies, and the re-engineering of supply chains due to geopolitical concerns and after the Covid-19 pandemic.

“All of those are very credible reasons to suggest things might be more inflationary than less inflationary compared to the last 15 years,” the Melbourne-based manager says.

“The odds of inflation have ­increased but there’s no commensurate reallocation of assets to ­reflect that. The asset allocation is telling you that we are going to ­revert to what we had before the pandemic.”

As a value investor, Selby-Smith is used to taking a contrarian view. However, his approach shows that investors don’t have to fight the market consensus.

Selby-Smith takes the view that there is a wide range of things that can happen, but he moves ahead by focusing on the process for his worldwide search for undervalued stocks, a strategy that missed out on the extraordinary tech rally but has outperformed its benchmark.

The $1.6bn fund that Selby-Smith manages alongside Chad Padowitz has delivered 15.67 per cent for the year to June 30, higher than the MSCI World ex-Australia value index’s 14.25 per cent.