Which part of the market cycle are we in: stagflation or deflation?


CIARAN RYAN: In the past two years the world has witnessed the fastest bear market and quickest subsequent recovery. Now, increased levels of inflation and slow global economic growth have led to deliberations between experts about what part of the market cycle will come next – stagflation or deflation? Based on the evidence, it is possible to make the case for either.

Well, joining us to unravel this is Adriaan Pask, chief investment officer at PSG Wealth. Hi, Adriaan. Good to talk to you again. What aspects of inflation and interest rates are you not seeing in the current debate?

ADRIAAN PASK: Hi, Ciaran. Once again, thank you for having me.

I think obviously the current debate around inflation has really revolved around how that could lead to higher interest rates in an effort to bring inflation down, and then how that introduces the possibility of not only lower growth, but also potential recession – in particular in the US – and what the impact would be on the broader global economy and markets.

So a lot of the debate has been focused around those specific topics, but there are two elements that concern us that aren’t being featured in the debate at all, really, at the moment.

The one is really the impact of inflation on the broader unit trust industry, especially how it impacts inflation-benchmarking, and whether clients really understand the dynamics between inflation, interest rates and the performance of the products that they’re using at the moment.

And, second [there] is the risk of deflation downstream. So, as I say, the current debate is largely around stagflation – so lower growth and inflation at the same time – and not really any attention is being given to how the risk of potential deflation is actually increasing significantly, the higher inflation rates go up.

CIARAN RYAN: I’m glad you defined stagflation for us – that’s low economic growth and at the same time rising inflation. But how do you at PSG Wealth see stagflation, and what impact could it have on us?

ADRIAAN PASK: Well, first and foremost I think the slowdown would mean that there are [fewer] people involved or participating in the economy. So GDP numbers go down and, more importantly, earnings numbers are affected through corporate profits. So from an investment perspective that’s obviously quite important.

But if you suffer lower earnings at the same time that you are in a higher inflationary environment, that’s exactly the opposite of what you really need. Because if inflation is trending upwards – really, what you should be after, is investments in asset classes that will help you protect the real value of your money so the net gain after inflation has been taken into consideration, so that you can build your wealth over time, net of inflation.

But that becomes incredibly difficult as inflation ticks up, and at the same time you see interest rates tick up, and that typically has a negative impact on markets. And then obviously from a stagflation perspective it’s not ideal, and you are looking for signs that it might be relieved in some way or form.

So if you look at the drivers of inflation, you would hope that some of those things start to move back to more normalised trend levels.

But if you look at oil prices, for example, or energy prices in general, those are really the things that have been massive drivers in the inflation number and they might recede over the short term because they’ve run so hard in recent months. But at the same time the lack of investment in that space puts a structural tailwind behind the prices.

So we see a scenario where we are potentially forming a high base moving lower, and then a brief period of deflation followed by a continued period of stagflation again.

So it really matters quite a bit in terms of how you interpret that timeline into your investment strategy.

So long story short, in terms of investment strategy and a stagflationary environment, you typically want to focus on businesses that have the ability to protect margins, because you sit in an inflationary environment where your costs are escalating quickly.

If you are investing in businesses that have a very strong handle over cost, then that’s good.

I think in this environment the key is not to overpay where there might be lofty expectations priced into assets or securities, and then in the end the corporates struggle to meet those lofty expectations and then obviously derate from there.

So I think we are much better poised to be in a position where we invest in businesses where much of the risks have been priced in, and rather allow them some flexibility to surprise on the upside.

CIARAN RYAN: That is a bit concerning – that we are looking at the potential for deflation and stagflation, one after the other. What is the likelihood of deflation?

ADRIAAN PASK: Well, it’s a strange position to be in because, as I say, there isn’t much talk about deflation.

Deflation is really the opposite of the narrative that’s currently doing the rounds, because we are seeing inflation numbers coming through at very high levels. If you look at what’s being predicted through the UK … last week it started with Credit Suisse putting down a number of 17% for UK inflation and then after that two of the other investment banks came through with a number of 20% and the more recent 22%.

So these are massive, massive numbers and obviously hitting headlines – and everybody’s trying to just manage for an inflation shock that’s coming.

But the reality is that, the higher inflation goes, the higher the likelihood of subsequent deflation – and that’s just because you’re creating a very high base effect in the numbers.

You’ll remember, for example, when we went through the Covid period, when we reported very high economic growth numbers following the depths of Covid – all that happened is a recovery to previous levels.

That recovery implied a percentage gain from the low base of growth to a normalised level, but the reported number was a high percentage. I think we’ll see the opposite of that in the inflation numbers. So we’re setting a very high base now on the inflation number, and it’s likely that prices will remain higher than trend, but lower than current. And the ‘lower than current’ is really the important part, because if you measure it on a year-on-year basis, we might actually see that deflation number coming through.

That’s the piece of the puzzle that’s not being reported anywhere.

I think if you ask most people they would say it’s an impossibility because it’s pure madness thinking about a deflation environment where the UK is expected to print [inflation] numbers in excess of 20%. But the key question is what comes after that. As I say, statistically, it means that the higher the inflation runs at the moment, the higher the probability that you’ll see deflation shortly after.

But I think even more important than that – and this is really the question that we are grappling with at PSG – is even if you do see that, will it be a short-lived deflationary period or could it be sustained?

We are definitely not in the camp that says it will be sustained, because we do think there are pricing pressures that will mean that prices remain higher for longer. I think it’s purely a short-term thing where the base effects at the moment are simply too high. So it will be short-lived, but it will be a surprise to markets, I would think.

CIARAN RYAN: I guess it’s a challenge for unit trust managers who are looking at this scenario of deflation. How do they adjust to an environment where they’re using inflation as a benchmark? What’s the solution to that?

ADRIAAN PASK: It’s exactly what we’re seeing at the moment, and it’s not the first time. This is something that’s quite cyclical where the funds that use inflation benchmarks – a very good example, in our environment in South Africa, [are] the typical funds that brand themselves as ‘stable’, ‘preserver’, ‘cautious’, ‘low equity’ – those are typically mandates that hold about a third in equities, and they generally aim for an inflation-plus-3% type of return.

In this environment where inflation is high, inflation-plus-3% is north of a 10% return. At the same time, typically when inflation is high, interest rates are moving higher to combat that same inflation. And as interest rates move higher, asset classes fall under pressure. The only thing that keeps moving forward is cash rates. But typically equities and bonds do take some pain there. So you actually have a negative relationship between what your investment is doing and what your benchmark is doing.

If you plot this on a graph, you end up with something that looks a bit like a DNA strand – with completely opposite directions at times, and then brief periods where they align, and then they go in the other direction again.

Why this is important is when investors start to look at their various reports, whether your wealth manager is benchmarking you on inflation or whether your low-equity fund is looking at inflation-plus-3%, investors are going to start to notice that things aren’t looking quite right.

I do think in some cases they might even think that it’s specific to the funds that they’re using. But we’ve gone through analysis of the low-equity funds at the moment, and there are literally only a handful that have managed to beat inflation-plus-3% over the last three years.

So it is going into that cold period, but then that’s typically followed by a period where virtually all of them generate that return. So it blows a bit hot and cold as a sector. I think it’s important to take note that the investment horizon of the product may be three or four years, but the prevailing interest-rate and inflation cycles are much longer than that.

So these investors in these products are going to have to adjust their expectations a bit to ensure that they interpret the performance of their products a bit more accurately.

What I could suggest as an alternative is looking at the returns on a relative basis. So look at what the other funds in the industry are doing [and] see if it’s realistic to expect the return of inflation-plus-3%. For example, in the balanced-fund space, typically it’s inflation-plus-5%, or 6% even in some cases.

Just be wary, I think, is the cautionary note. Just be wary of these inflation benchmarks. They make for a bit of a messy interpretation of your actual success at the moment.

CIARAN RYAN: Interesting times ahead. Adriaan Pask is chief investment officer at PSG Wealth. We’re going to leave it there. Thank you, Adriaan.

ADRIAAN PASK: Thank you very much, Ciaran.

Brought to you by PSG Wealth.

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