How to invest for inflationary times
Charlotte Yonge of Troy Asset Management tells Merryn Somerset Webb how to protect your portfolio
Until very recently when we looked at the MoneyWeek investment trust portfolio we felt both very grateful to Scottish Mortgage (its performance has made us look fabulous) and a bit nervous (we felt sure that many of its holdings were grotesquely overvalued). That made us very glad we had the likes of Personal Assets Trust (which aims to protect capital) in the portfolio too. Our hope was that when Scottish Mortgage (LSE: SMT) stumbled, Personal Assets (LSE: PNL) would ride to the rescue. It has. The former is down around 20% over the last year (having recovered a good bit from its lows in the last few weeks) and the latter up 7%. That isn’t offsetting all our Scottish Mortgage losses, of course (what could!). But it’s still very welcome.
What better time then for us to talk to Troy Asset Management’s Charlotte Yonge (Troy manages Personal Assets). We start by talking about inflation. Until recently most fund managers have been on board with the central bank view that the high inflation numbers of the last year have been transitory. That this is not the case has taken them largely by surprise.
Not so Troy. There was a huge explosion in money supply immediately after the financial crisis of 2008, says Yonge – that’s when the firm started to buy index-linked bonds (“linkers” – which protect against inflation). As it turned out, Troy was early. The newly printed money went directly to the banks – who were pulling back on lending at the time. That meant there was no transmission mechanism – “no link from the money being on the balance sheet of a bank to actually being in someone’s pocket”. Today things are different. Thanks to Covid-19, we have transferred payments directly “into the hands of people who are spending them now”. That has led to a genuine rise in demand.
Inflation changes behaviour
Still, I ask, surely by now most people have spent the extra cash? In the UK, credit-card debt has begun to rise again, for example. In Britain, we are closer to normal, says Yonge. But the US is behind us on re-opening – and that cash is still sitting on the balance sheets of households. Look at what household savings have done on a cumulative basis since early 2020 – and you will see they are now “around 20% of what the average US household spent in 2019”. All this “firepower” is just sitting there representing “a huge amount of pent-up demand”, which is only just beginning to be unleashed. Alongside that you have wage inflation. This is the key thing to watch. The owners of capital have done very well over the last few decades. Labour has not. Now there is not just a shortage of workers in all sorts of areas (driven in part by the early retirement of the baby-boomers), but there is also “a political mandate, a real political support for, particularly, lower-income demographics to earn more”.
Right now it is tempting to dismiss the idea that wages will rise with or beyond inflation on the basis that workers are less organised and less unionised than they were in the 1970s. But that might, says Yonge, be to look at things the wrong way around. “Even though union membership was just structurally higher back then, the wage inflation actually followed the higher cost of living” – in other words, workers may well organise in response to rising prices.
The key is to think about how the persistence of inflation will change behaviours. Consumers may think “oh, my money’s going to be worth less in a year’s time, I’ll spend it now” – which clearly doesn’t help. But there is also the psychology of companies and how they respond on the pay front to keep an eye on. This is what makes the war in Ukraine so important from a macroeconomic point of view: by disrupting supply lines further, forcing food prices up and giving us an even more extreme energy crisis than we might have had anyway, it has delayed peak inflation. “I think that will change behaviours.” Inflation may not be heading back to 1970s levels, and with so many different elements coming together it is hard to see where it will end up. Overall the best we can say is that it is probably going to be persistently “higher than in the past”.
Two assets for inflation-proofing
This brings us neatly on to how we might protect ourselves. There are two main asset classes in Personal Assets Trust that work for this, says Yonge. The first is index-linked bonds. Look at prices for shorter-dated bonds (maturing in the next two to three years) and you can see that reality is beginning to be priced in. But go further out – say five years – and the US bond market is not pricing in any sustained inflation overshoot. Buy at these prices and you are paying no premium for the uncertainty around inflation at the moment – and “you are getting pretty good value inflation protection”.
“There are two main asset classes that offer inflation protection”
The second asset class is gold. People still think of gold as a commodity, says Yonge. They shouldn’t.
“It is really a currency that central bankers can’t print. It’s finite in its supply. It’s been around, unlike some other alternatives, for millennia, so it really is wellestablished as this alternative store of value.” It also has diversification benefits – providing some protection in times of geopolitical instability and when markets are falling. However, the real reason to hold it is that it has historically been “very, very good at protecting against monetary instability”.
What bitcoin and growth stocks have in common
How about crypto? Supporters like to think that its independence from fiat money systems means that it is on track to be the “new gold”. Not on the evidence so far, says Yonge. So far in this crisis it has behaved “more like a risk asset” than a diversifier or protector (the price has moved more with growth stock prices than anything else). Back to gold. Is holding it ethical? After all, anyone who has seen the environmental carnage any mine can create might wonder if it should be in the Troy Ethical portfolio (which it is). It can be, says Yonge. In the ethical fund “we’ve, effectively, put in a binary screen, whereby we maximise the gold that has been responsibly sourced. And the way that we could ascertain that is by auditing the gold, so auditing the physical bars that underpin the exchange-traded commodities (ETCs)”.
The other way that investors have – over the very long term at least – protected themselves from inflation has been via the equity markets. Can that work now? As an asset manager, Troy feels a little nervous, says Yonge – something that is reflected in its equity allocation (currently around 35% of the portfolio of Personal Assets is in equities). The main reason stocks have done so well until recently is “also the reason that they could come crashing back down”. The cost of capital – essentially what it costs companies to borrow or raise funds – went “right down to zero during Covid-19”, something that benefited a lot of companies with very low (or no) profits and saw “a lot of growth stocks go to the moon”. As the new inflation dynamic is recognised – as is the fact that the world is a pretty uncertain place – there is an obvious risk that the cost of capital actually starts to reflect these things, and that the share prices of the growth stocks continue to be hit.
That said, says Yonge, “the kinds of stocks that we would invest in, the ones with really, really strong profits that have grown those profits for years and years and are well established, the prices haven’t come down very much”. They’re fine – but “not yet at a level where we’re really excited to be able to add to equities”.
We move on to the top holdings in the portfolio. They move around a bit – Google’s parent Alphabet and healthcare firm Medtronic are relatively recent arrivals in the top ten. But “we’re very discerning, so we’re not changing the portfolio around every month, every year. We’re just looking for those really exceptional businesses, frankly. They have to hit a very high bar, and then once they do, they have to be at a valuation where we think we’re being paid to take the risk. So, quite often, we’ll have done the work on a company. Visa (NYSE: V) is an example that actually entered the portfolio during Covid-19 in 2020. We did the work on that in 2015, and we waited for what ended up being a really attractive valuation entry point throughout Covid-19, to build what’s now a 4% holding.”
Which stocks can thrive in the new era?
There’s a bearish case to be made for Visa (new payments methods leaving it behind), but Yonge isn’t having any of it. The reality, she says, is that the likes of PayPal can’t exist without the card networks – “it effectively relies on Visa and Mastercard above everyone else for acceptance around the world”. The same goes for the “buy now, pay later” disruptors (they need Visa) and for all the other fintech companies that people keep saying will eat Visa’s “competitive moat”. Again, “the opposite is true”. They rely on Visa, and Visa benefits because ultimately, the more payments that go from being in cash to being on card, the better. The truth is that the “disruptors are actually just enablers of the network that still sits at the heart of the payments system”.
What of the bearish case for food giant Nestlé (Switzerland: NESN) – another top-ten holding that ran into some social-media trouble over its Russian operations last week? There is a perception, says Yonge, that Nestlé sometimes doesn’t quite get it, or isn’t doing the right things. “And we’d actually really strongly disagree with that.” It has taken out a lot of its nonessential products from Russia and is currently running its operation there (and remember it has thousands of employees in Russia) at zero profit.
“This is a company that is choosing to take a neutral position and, frankly, not penalise civilians in that country.” The Nestlé of 30 years ago – the one that still affects the way people think about it – is a really different business from the company today. Today’s Nestlé is “incredibly progressive, particularly when it comes to environmental issues” – it just doesn’t get the credit that it should for it. However, in time it will: “I think it’s a competitive advantage there that just hasn’t been fully tapped”.
“A rising cost of capital could send stocks crashing down”