Ben Wattam

So I’m going to just run through, as Ben was saying, just a bit about inflation from a market’s perspective and economic perspective, because people talk a lot about inflation, especially at the minute but I don’t know whether people understand inflation from an economic perspective. So inflation is just a measure of changing prices each year. And if you look at the Bank of England or the government ONS, Office of National Statistics, they’re talking about different inflation measures. There are loads of different measures of inflation we use for different things. So we might use RPI, for various things like train fares or pension increases, or the Bank of England use CPI consumer prices index, the ONS use CPIH as the official measure for UK inflation, which includes housing. But the Bank of England’s use core CPI, strips out energy and food and things like that. So there’s lots of different ways you can measure price increases. And inflation, I think you want it to be like your porridge in the morning, you don’t want it too hot, you don’t want it too cold. The picture on the right is of in Venezuela in 2017 of the amounts of money needed to buy chicken. When you get to that sort of level of inflation, the economy really struggles to work.

So what causes inflation, there’s two main things. One is supply problems, which is called cost push. And the second reason is, is demand problems ie too much demand, which is called demand pull. Now, I would argue that the left-hand side the cost issue is usually temporary. The right-hand side is usually permanent. Just a very quick example, if you have a spike in oil prices that we’ve seen recently, that is usually a temporary effect. It’s not that common for all prices to continue to rise at that level year on year, which is what we need for inflation. However, on the right, such as things like wage growth, that is more of a year-on-year factor, so it’s usually a permanent issue. So what’s been going on at the minute? Well, this was a comment from central banks this time last year. And they’re all saying it’s basically a cost push issue, it’s all going to be temporary and transitory, which was a key word that they were using last year. And this is their forecasts from the Bank of England on the left and the Federal Reserve on the right for inflation over the next couple of years. And they weren’t really worried. They were saying that we’re going to peak at high twos this year, maybe get to 3%.

So what’s happened? So two obvious things have happened. One is obviously the war in Ukraine, and the impact of COVID restrictions in China that’s affected supply chains. So you can see from various different charts here, on the left, we’ve got commodity prices spiking, in the middle we’ve got gas prices. And on the right, we’ve got shipping container prices. And I don’t have to tell you that all of these have spiked quite sharply in the last year, it may be interesting to know the gas price in the middle, the US has been quite insulated from what we’ve experienced in Europe because they have their own gas supplies. So it’s not been quite as apparent from the US situation. In the UK, this is the ONS’ latest data as to what’s driving inflation in the UK. And you can see the two biggest areas of impact has been housing and transport, which is primarily electricity, gas, fuel, and things like petrol prices and diesel prices as well. That’s the kind of the maroon colour and the light, the greeny blue colour as well. They’re the two dominant factors of inflation. So that still suggests that’s still a cost push issue that it’s a supply issue that’s driving inflation at the minute.

So what’s happening. So this is a chart showing what investors think interest rates will be at the end of 2020. So you can see in the middle of 2021, investors weren’t thinking interest rates, were really going to go anywhere, for 2022. And you can see that big spike in the last six months that investors now think interest rates in the UK and US will be between two and two and a half percent at the end of this year. Now, this is not the right time, in my opinion to be raising interest rates because with the economy slowing a little bit in the US and the UK, you want to be raising rates in a in a strong momentum, part of the economy not when we’ve got a slowing economy, you want to be raising interest rates before we have inflation spike, not when we’re having an inflation spike. So I already think that the central banks have made a policy mistake but they’re too late to the party to affect inflation as we’re seeing it at the minute.

And if you look at what the Bank of England are projecting as well, the left hand side is if we kept interest rates at half a percent. This is what the Bank of England think inflation will do in the next few years. On the right hand side is if interest rates go up as expected. So they go to two, two and a half percent later this year. And you can see that inflation doesn’t really change, which again suggests that it’s cost push still that the Bank of England are thinking is driving inflation, because rising interest rates in the UK doesn’t affect food prices, it doesn’t affect the price of oil, so they’re still thinking inflation is going to fall irrespective of what they do to interest rates.

So what are they saying now? So both the Bank of England and the Federal Reserve, and now talking about something different, both of them are talking about wages. Especially Jerome Powell in the US who sounds almost like he’s panicking about levels of inflation at the minute. So why are they getting really concerned when everything is suggesting that it is still cost push inflation is coming down. So this chart looks at wage growth in the US over the last 40 years or so. And you can see in the 1970s, when we had high inflation previously, whilst it was started by an oil shock with OPEC, it was actually wage growth that caused the high inflation levels in the 1970s, since we’ve had wage growth pretty much under control, but you can see wage growth is now spiking again. Now, what causes wage growth, so this chart on the left is from the UK. So this is things that affect wage increases year on year. So we have things like productivity, productivity has been pretty poor in the UK, for probably two decades now. We have slack in the labor market, we don’t have any slack anymore in the labor market. The main driver is inflation expectations. Because if you think inflation is going to be 7% a year for the next few years, you’re going to want a 7% pay rise. If you think inflation is going to be a 2% a year for the next five years, you’ll be happy with a 2% pay rise. On the right, you can see the expected pay rises for 2022, which is nearly about 5%. So we’re definitely having a spike in wage growth. Now, this is looking at expectations over 5 years and 10 years in the US, concentrate on the blue line, the blue line is inflation expectations over the next 5 years on the left and 10 years on the right. And you can see that whilst inflation expectations have been rising, they’re still around 3% level. So in the US, they expect inflation to be about 3% a year for both the next 5 years and 10 years. So investors are still thinking that central banks have inflation under control, we’re not going to have inflation of five or 6% a year, like we’re seeing at the minute for the next 5 or 10 years.

Now, what does it matter if interest rates go up anyway? Well, a big impact is on the consumer and in particular mortgages. So on the left hand side, you can see the 30 year mortgage rate. So a lot of US mortgages are fixed for 30 years. And you can see that rate is now at its highest level in over a decade. But there’s been a big change in the mortgage market both in the US and UK. The chart on the right shows the amount of floating rate mortgages versus fixed rate. In the UK now only about 20% of mortgages are floating rate that is affected by interest rates. Today, the majority is fixed rate mortgages in the US its about 5% of mortgages are now floating rate. So that impact of rising rates doesn’t have the same impact on the consumer anymore. Also, the consumer is actually in pretty decent shape, partly because of COVID. So in the US consumer deposits are about two and a half times higher than they were pre pandemic. And the cost of servicing debts is pretty much at an all time low. So the consumer both in the US and UK isn’t actually in pretty good shape. Now markets have taken fright by the panic that central banks seem to be going through at the minute. So three areas that we invest quite heavily in three of the bottom lines. So the blue line is the US technology sector, the NASDAQ. The grey line is the smaller companies sector in the UK, that’s all sectors. And the green line is smaller companies and healthcare. All three have been hit quite hard. The red line is the UK large cap index, which is full of things like mining oil and gas banks, that’s actually done quite well.

But inflation should actually be pretty good for companies for profits. The chart on the left shows that higher levels of inflation usually means higher levels of earnings growth. And so far this year, we’ve seen good levels of earnings growth both in the UK and US. In the middle, expectations for earnings are still quite strong this year and next. And on the right hand side is a measure of expensiveness of markets and you see that most markets do look quite cheap still at the minute. So what we’ve been doing this year to date, is we’ve been adding a bit more diversification into portfolios. Because whilst we don’t think inflation is actually going to be as scary as everyone thinks at the minute, and rates probably won’t get to where central banks are expecting. The risks have increased. So we’ve added a bit more diversification. So these are a few examples of things we’ve added to portfolios. So in the top left, we’ve added a energy storage fund which is battery storage, which helps balance out supply and demand in the power grid in the UK. The top right is a firm called Aspect that does a thing called managed futures that should protect us if we get soaring energy prices, we have added things like infrastructure, Greencoat UK wind owns wind farms around the UK. And we’ve added two commercial property companies as well, that has really strong inflation protection. So just to summarize, central banks are definitely playing catch up. The issue of central banks we’ve seen at the minute, they’re very dependent on short term data. And we can see inflation spiking. They’re way too late to be raising interest rates to affect this inflation spike we’re seeing at the minute. I think, as we go through the year, and the data on inflation might soften somewhat, especially in the US, that impulse to raise interest rates is going to weaken. The Federal Reserve meet today. And we’re expecting a half cent rise in interest rates, it’s going to be interesting to see what happens later this year, if they do get to that kind of two and a half 3% interest rate that people are expecting. Inflation expectations, we think over the longer term should still be around 2% to 3%. That inflation fear at the minute I think is at its peak levels. And the UK is slightly different because we’re going to have an impact on energy later this year with the October price rise again, we’re going to see, but next year is the important year for inflation, especially in the UK, we’re going to need another shock from a supply point of view to see inflation at these sorts of levels again. Consumers we think are in good shape, they still have lots of savings, and wages are picking up. So whilst this year might be tough because it’s a big impact on consumers that aren’t used to such big rises in their energy costs and fuel costs, we still think consumers are okay to kind of weather this storm. Markets are pricing in quite a lot of bad news at the minute. So valuations on the whole look quite attractive. But no one’s perfect. And we appreciate that we might be wrong. So we’ve added a few other assets into portfolios that should help protect if we continue to see volatility in markets. So with that, I’ll hand over to Tim.