Inflation is the 2021 'Grand Debate'

Financial markets have proven too much of an enigma for many an investor and share market commentator in 2021. Is it all about elevated valuations, an abundance in liquidity and the come-back of Value vis a vis Growth?

Or is there a lot more to digest in order to explain the often extreme and seemingly illogical day-to-day volatility, while share market indices are near all-time record highs, and holding up?

Probably the most apposite assessment of financial markets this year is via the Grand Debate that is raging across the five continents: are we at an early stage of a new inflationary period, or are markets jumping at shadows and will we all look back next year and wonder what all the fuss was about, really?

The answers to that all-important question are formulated with fierce conviction, amidst utter division. The conviction on both sides of the argument seems so high, neither side seems to be able to understand why the others cannot see what they see.

If ever there was a Mexican standoff in global finance, this year's Grand Debate would be it.

In one corner we have the inflationists who see a major break with the past decade as the economic V-shaped recovery intertwines with generous government spending and overly accommodative central bankers.

Closed borders, interrupted supply chains, geopolitical tensions, climate change and water shortages, major infrastructure spending and cashed-up consumers; it all points in one direction: inflation is about to go through the roof. History won't be kind to today's policy-makers.

In the opposite corner we have the deflationists who only see inflation spiking -temporarily- because last year's reference numbers are so low, while closed borders and interrupted supply chains will be resolved, albeit not immediately.

The real damage done to economies is not reflected in standard data and surveys, so goes the counter-argument, while megatrends such as technology driven-disruptions and ageing populations continue to keep a lid on inflation, on top of zombie companies, the global search for income, a massive mountain of global debt, and economic momentum that is already showing signs of decelerating.

The return of inflation favours higher bond yields and lower valuations for risk assets. Hence, investors in the first corner are buying financials, as they benefit from steeper bond yield curves, and producers of commodities like oil and gas, iron ore, copper, lithium and cobalt because the economic recovery is pushing up prices and inflation will exert itself on the back of higher input prices, which hurts those businesses that need to purchase commodities to manufacture their products.

Downward pressure on asset valuations also means you sell last year's covid-winners, as well as those companies that have benefited from the low growth/low yield/maximum stimulus environment that has characterised the post-2015 period. Add the economic recovery and it is not difficult to figure out why cheaply priced cyclicals and low-quality companies have been the true beneficiaries in equities since November last year.

Most inflationists are also big fans of owning gold, and possibly silver too, but here the experience thus far has not been equally as positive.

This is, as I never tire to explain because gold is actually a rather flawed instrument to seek protection against inflation. It only works under certain circumstances inside a certain context, like volatile growth and geopolitical tensions throughout the seventies combined with run-away inflation. It does not work with only a little bit of inflation that subsequently translates into higher yields on US Treasuries.

Like the Romans would say: quod erat demonstrandum. (In case nobody taught you Latin at school: the past year has delivered plenty of evidence).

But investors in the opposite corner refuse to budge, calling falling share prices in quality growth and technology companies the true opportunities in today's share market. You really think those Australian banks are now better companies with more and sustainable growth ahead in the years to come? You better think again!

It goes without saying, the opposite corner doesn't think there is another Commodities Super Cycle building either.

On Friday, FNArena published the views of Janus Henderson and T.Rowe Price on the current spike in US inflation: https://www.fnarena.com/index.php/2021/05/14/are-shock-us-inflation-numbers-a-concern/

The added observation here is that most inflationists have been ringing the alarm bell for many years, and they have been proven wrong time and again, except for the occasional brief period such as the second half of 2016. However, this does not by default imply they cannot be right this time and market momentum since November -six months ago- has been unequivocally on their side.

In the same breath, market momentum and the current spike in inflation can be explained through a multitude of different factors. Six months does not automatically create a new era. Market momentum will spin on a dime if growth data turn sour and inflation numbers start deflating again.

Making matters slightly more complicated, these two opposing corners are not the only divergence that explains this year's volatility in financial assets. There is no agreement on how central banks will respond to higher inflation either.

By now, you know how this game works.

In the one corner, we have those who find solace in the steadfast resoluteness of central banks' messaging that inflation is not a genuine problem. It can run above 2% for a while and central banks can reign it in through less bond-buying and higher cash rates from the moment both economies and inflation seem on solid footing.

Central banks remain convinced this year's spike in inflation will deflate later on, making any policy adjustment at this stage premature.

The opposite corner tends to be a little more verbose. Here investors think central bankers are -again- deluding themselves and already making serious policy error by not responding to the early upward surprise in US inflation. History shows, these investors warn, that once inflation takes hold, it can only be reigned in through drastic measures that will put the economy into recession, and the global financial system at peril.

Central banks may not wish to act anytime soon, but they will be forced to according to the credo among critics.

Those critics of today's central bankers will buy gold because when the system ends up on the verge of collapsing, yet again, the world will be looking for safe havens that do not follow most other assets down into the abyss.

An important narrative as to why investors have been investing in crypto-assets in recent years relates to the eventual collapse of fiat currencies and the system; this narrative will be truly tested when uncertainty and volatility start dominating the landscape again, as it will at some stage (exact timing unknown).

The opposite view is that cryptos are but evidence of global excess liquidity looking for anything but a term deposit.

Take your pick. The years ahead will be interesting, to put it mildly.

So how do we respond as a sensible investor who doesn't like to lose his proverbial pants and shirt if/when the Grand Debate of 2021 results in a different outcome than what we expected, and what we have prepared for?

I think the obvious answer points in the direction of portfolio diversification. All or nothing seems like a high-risk strategy that would not suit most Australians who manage their own portfolio ahead of or during retirement. The differences in outcomes for each of the aforementioned views and prognostications are so wide that, without diversification, the risk to portfolios seems a lot higher than is usually the case.

Depending on the direction of the Grand Debate over the remainder of 2021 and in 2022, beaten down share prices in defensives and Growth and technology stocks today represent either a fertile hunting ground for investors willing to look beyond the short term, while stomaching hefty volatility that is to remain with us, or they represent nothing but a value trap in a downward oriented trend that will pull share prices much, much lower still.

Equally, the outcome of today's Grand Debate will determine whether financials and resources stocks have already peaked, or will peak in the not-too-distant future, which given the nature of these leveraged plays on higher bond yields, economic growth and inflation can have a devastating impact on where share prices might ultimately end up.

I don't think it is likely this Grand Debate will end either way anytime soon and it won't be long before investors locally start concentrating on what exactly the August reporting season might bring.

I anticipate strong operational momentum for many companies that are on my radar. The likes of Aristocrat Leisure ((ALL)), Bapcor ((BAP)), Carsales ((CAR)), Hub24 ((HUB)), REA Group ((REA)), and many others have guided analysts and investors towards better-than-previously-forecast profits, but August, I think, will be mostly about what can investors expect to hear in terms of outlook and guidance.

Can we expect much clarity from these businesses when the rollout of vaccines is still not at pace and borders might remain closed for another year or so?

At this point, the FNArena Corporate Results Monitor post-February is unequivocally positive (read our reporting season coverage) and many a resources company seems due a profit upgrade on the back of higher-than-expected commodity prices, which should provide support for share prices.

Smart investors will be thinking about and looking into alternative scenarios whereby the current status/market momentum will be challenged, even though there is no clear indication as yet this will happen.

FNArena offers impartial and independent analysis of financial markets, on top of proprietary tools and applications for self-researching and self-managing investors. The service can be trialled for free at FNArena. 

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