Equities and inflation: a good match?
Equities has traditionally been “a good place to camp out” in an environment of higher inflation, argues Walter Scott client investment manager George Dent.
Dent observes that the last time UK inflation was at a meaningfully high level was in the 1980s. At the start of that decade, Pink Floyd’s ‘Another Brick in the Wall (Part II)’ was at number one in the UK singles chart2, he notes.
However, Dent says inflation is now verging on that level and is likely to remain high over the medium term due to a combination of factors. These include elevated energy and raw materials prices, higher interest rates, a tighter labour market, and supply chain issues, particularly in certain Asian countries due to their zero-Covid approaches.
But Dent thinks those investing in equities, particularly quality growth companies, are well placed to ride out the bumps in the road created by higher prices.
For one thing, Dent says the pent-up demand in economies generated during the pandemic is a positive for equities, with any subsequent spending wave likely to benefit certain companies.
Moreover, however, he says a look at history shows that equities have held up well during periods of higher inflation.
Throughout the 1970s, for example, UK CPI ran at an average of 13.1% a year and equities delivered marginally positive real returns of 0.4% a year3, says Dent. He adds while not necessarily being a great wealth creator, equities did a reasonable job during that decade of preserving wealth.
But in the 1980s – a decade more representative of the current expected level of inflation – CPI averaged 7.6%, with equities delivering a real return of 11.7% over the period4, notes Dent.
In recent years, record low rates have acted as a strong tailwind for equity prices and Dent says a cynical observer might ask at what level interest rates were during the 1970s and 1980s.
“In the 1970s they [interest rates] started at 8% and finished at 17%, but it certainly wasn’t a tailwind for equities,” says Dent. “In the 1980s, rates started at 17% and dropped to around 14/15% at the end of the decade5, so a bit of a tailwind, but not a huge one.”
Dent says during the Second World War years (1940-1950) there was “reasonable inflation (6.1%) and a reasonable return on equities (6.3%)”. During the First World War era (1910-1920), there was an inflationary environment (9.7%) and while equities were down 8%, they performed better than UK gilts (-10.8%), he says.
“Looking back at the last 100 years suggests equities are not going to be too bad a place to be if we are going into a more inflationary environment,” he concludes. But, Dent says, it is important for investors to remember that not all equities are created equal and that not every company is well placed to navigate a period of higher inflation and higher interest rates. He argues that investors would be best served by quality growth companies, which Walter Scott defines as highly profitable businesses, with strong balance sheets and pricing power. It’s these characteristics that should allow companies to weather a more inflationary environment with relative ease, he adds.
Dent says: “We don’t change our spots and do things the same way irrespective of whether we are going into an inflationary environment or otherwise, so these are all core attributes we look for, along with businesses that benefit from good structural tailwinds.
“Put those two things together and it leaves you with a skew towards areas like healthcare and technology and away from sectors like financials.”
In the healthcare space, Dent says Walter Scott invests in one of the global leaders in the treatment of diabetes. He says this company is resilient to inflationary pressures due primarily to its high levels of profitability but also because it does not have to rely on price-sensitive raw materials.
He also notes a Japanese automation business that makes sensors. Again, he says this business is highly profitable with “great pricing power”, but more importantly, it should actively benefit from wage inflation. This is because the more wage inflation there is, the greater the incentive for companies to automate their processes, he adds.
Dent also highlights a payroll processor in the Long-Term Global Equity strategy, which he says is a good way for investors to benefit from a rising rate environment if they aren’t comfortable investing in banks, which can be “highly leveraged and opaque”.
Payroll often becomes deeply entrenched in businesses and as such, it has sticky customers, Dent says. Payroll companies can also benefit in tandem with rising wages and in a higher interest rate environment because they tend to sit on a lot of cash.
He adds: “Our time is best spent not worrying about where markets are going over the next 12, 18, 24 months, but instead focusing on trying to find and align our clients with a select group of high-quality industry leading growth businesses.”
Investment Managers are appointed by BNY Mellon Investment Management EMEA Limited (BNYMIM EMEA), BNY Mellon Fund Managers Limited (BNYMFM), BNY Mellon Fund Management (Luxembourg) S.A. (BNY MFML) or affiliated fund operating companies to undertake portfolio management activities in relation to contracts for products and services entered into by clients with BNYMIM EMEA, BNY MFML or the BNY Mellon funds.
1 The value of investments can fall. Investors may not get back the amount invested.
2 ‘List of UK Singles Chart number ones of the 1980s’, Wikipedia, 15 March 2022.
3 BNY Mellon IM using data from BoE Long-run inflation series and Barclays Gilt Study 2021. For UK CPI, average yearly UK Retail Price Index going back to 1900 is utilised.
4 BNY Mellon IM using data from BoE Long-run inflation series and Barclays Gilt Study 2021. For UK CPI, average yearly UK Retail Price Index going back to 1900 is utilised.
5 Bank of England, Official Bank Rate History Data from 1694.
910126 Exp: 26 September 2022