Back to the future

26th Apr 2021

Seb Jory on the value of active portfolio management in negotiating inflationary environments.

“History doesn’t repeat, but it does rhyme”
–Cliché often attributed to Mark Twain

The reader is going to have to forgive the high incidence of charts in our normally quite printer friendly Bugle – inflation is a dry enough topic without reams of text that can be better said with pictures. You will also have to forgive some fence-sitting. We wrote on the case for higher inflation back in August, but today we step-back from the still raging debate and ask what do we do if. After all, we have already seen big opportunistic price hikes in the goods that consumers are actually able to buy – coffees, sheds, used cars and, most importantly, flux capaciter.

To find examples of brushes with genuine inflation – uncomfortable inflation – in developed markets we have to go back at least 30 years. Even then, the 5.8% registered on the US CPI in 1990 is not hugely anomalous, particularly since the 10yr bond yield was well above this level beforehand – real rates were healthy and the concept of a ‘negative rate’ would have been completely absurd.

No, to find a decent paralell with today’s set up we may need to go back as far as the ‘50s and ‘60s. Over this period the US saw both low inflation and rates, with equity multiples expanding greatly (sound familiar?). This was followed by, in 1965, a sudden unanchoring of inflation on the back of very large budget deficits to address inequality and civil unrest – along with, crucially, an easy and complicit Fed.

This reeked a bit of havoc in asset markets as the 10yr went from 3% to 8% (the UK from 4% to 9%) and what had been a multi-decade bull run for equities abruptly soured into a 20% sell off, then well over a decade of range-bound market indices – the DJIA only surpassed its 1965 inflation adjusted level nearly two decades later in 1984 (Fig 1). Fascinatingly, there was massive divergence in the performance of styles and sectors in this period. Small Caps were the best performing of all, returning well over 30% despite a market that was only up just over 5%. And, perhaps unsurprisingly, value also strikingly outperformed, with bonds among the negative returners, despite the much higher starting yields than we see today.

Now this would not be your base case – one might argue that markets and central banks are more forward-looking and should avoid triggering double-digit inflation in all but a total implosion of monetary stability and government prudence.

There may also be idiosyncrasies with the late ‘60s event that no longer ring true today – e.g. the Vietnam War or leaving the Bretton Woods system. Both seem a bit one-off. We can try to increase our sample size to get a better flavour of the ‘typical’ inflationary episode. One recent study[1] looked at inflationary ‘regimes’ in the US, defined as realised CPI rising materially through 2% before peaking.

Right out of the gate, we find that there is no such thing as a ‘typical’ inflationary episode – the range of outcomes is extremely diverse. The 1980 inflation saw stocks rally 18% versus a 32% sell off when oil prices spiked in 1972. However, looking at the 8 period average in Figure 3, we do note some clear patterns. Equities generally struggled, falling over 5% in real terms, interestingly, even more than 10 year treasuries on average. This is against a near 10% real return in all other periods – so a 15% difference. The best performing assets were commodities – we note that food and soft commodities were a persistent feature in that mix.

Another thing that particularly stood out to me was how the stock/bond correlation changes as inflation rises (Fig 4). This can be summarised as- ‘how much inflation is too much inflation’ for stocks. We see that above roughly 2% 3yr average inflation, we start seeing a positive correlation  between stocks and bonds – i.e. yields going up meaning stocks go down. Discount rates trump earnings upgrades and this might be where allocators would need to re-think portfolios.

[1] “The Best Strategies for Inflationary Times” – Neville, Draaisma, Funnell, Harvey, Van Hemert (2021)

Finally, we analyse the performance of styles and stock groupings in all of these post-War inflation regimes – do we get the striking Small Cap outperformance that we saw in the close macro analogue of 1966? Not quite. We can see from Figure 5, that 1966 was the strongest for Small Cap at +45%, although the 1980 inflation saw a similarly strong 32% rally. This is heavily counterbalanced in the +4% average of the other periods – which were lacklustre for Small Cap – and tended to be more related to cost inflation. The ‘flavour’ of inflation matters a lot, even if in general Small Caps do OK as prices rise.

Encounters with high inflation in the world economy have been relatively rare. They are also all quite idiosyncratic. Our sense is that whilst the 60’s analogue seems most apt for the current outlook, we must acknowledge that there are obvious differences. Momentum strategies have performed well in nearly all cases – we think this lends itself well to active strategies. One other consistency is that sheer beta, diversified and passive, also tends to struggle. This pattern is consistent to UK specific studies[1] too. Readers will probably guess that we think this would suit our funds quite well – active, specialist and Small Cap biased. We would welcome a return to markets less oppressed by low yields, more dispersed and ultimately more fertile for stock picking.

[1] “The Best Strategies for Inflationary Times” – Neville, Draaisma, Funnell, Harvey, Van Hemert (2021)


Seb Jory co-manages our TM Tellworth UK Select Fund, a large cap UK absolute return UCITS strategy


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