London - In our recent quarterly outlooks, we have written about the inevitable need for the global economy to "pay the piper." By that, we mean that we believe the huge amounts of stimulus injected into the economy during the COVID-19 crisis, both from central banks and governments, will come at a price.
Higher taxes, which are now being debated in the U.S. and U.K., are one element of this. Another important area is inflation, which is seeing upward pressure from the strong economic recovery and supply chain issues associated with the coronavirus crisis. According to a May research report published by Credit Suisse's global strategy team, "Inflation tends to be question number 1 in our client conversations."
The good, the bad and the ugly
Our CIO of equities, Eddie Perkin, has talked about "good inflation and bad inflation." Modest inflation is good for businesses and consumers. As we've learned from Japan's multidecade deflationary experience, zero inflation can lead to years of subpar growth and impair consumer spending. This is obviously a bad thing. Finally, we have the ugly impact of inflation — when it runs out of control. Most investors and management teams have little experience with this and one has to go back to the 1970s and 1980s to understand how rampant inflation impacted consumers, businesses and interest rates.
Pricing heading higher?
The topic of inflation has featured prominently in corporate earnings calls this reporting season, which is ongoing. From semiconductor shortages to logistical bottlenecks, it is clear that many companies are increasing prices to offset inflationary pressures. Ultimately, the duration of this pressure matters most. Interestingly, the same report from Credit Suisse states that about 90% of clients agree with central bankers who believe the rise in inflation will be transitory. These bankers are telling the market that inflation will be a temporary phenomenon, brought on by the extreme volatility of the COVID crisis. Higher unemployment due to COVID-19, coupled with the deflationary impact of technology and automation, could mean we return to the same levels of mild inflation to which we have all become accustomed.
We can expect this debate to dominate financial market commentary for the foreseeable future. If both inflation and bond yields move higher for longer, it could have a significant impact on asset allocation decisions, reshape portfolios and influence how investors value stocks and bonds.
Franchises with sustainable moats
The investment process for our international equity strategies concentrates on the sustainability of business models. We have tried to build portfolios of companies that can ride out any storm, from deflation to inflation. Pricing power has always been an important area of focus for us, where brand strength and market share/position play key roles. From industrial to consumer sectors, our companies' management teams are telling us that raw material inflation is running hot — at levels not seen for 10 years or more. Whether a leading semiconductor or consumer products company, we think that the brand, competitive advantages and durability of the franchises in our portfolios will see them through temporary or elongated inflationary pressures.
Bottom line: In conclusion, when clients ask about inflation, we think you should tell them it's real and the pressure is building. How high inflation may go and how long it will last are, of course, impossible to forecast. However, the international equity strategies we manage have been built to weather macroeconomic volatility over the long term, and we believe will be successful in doing so.