How to navigate the big risk worrying the pros

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One of the biggest economic concerns for asset allocators is the prospect of a return to a 1970s-style period of stagflation. 

To discuss the reasons why a stagflation shock is on the cards, and how investors can attempt to navigate this risk, Kyle is joined by Tom Becket, co-chief investment officer at Canaccord Wealth. The duo discuss prospects for funds, shares, bonds, and alternative assets.

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Kyle Caldwell, funds and investment education editor at interactive investor: Hello, and welcome to the latest On The Money podcast, a weekly show that aims to help you make the most out of your savings and investments. 

This week, we’re focusing on the topic of stagflation. We’re going to be talking through what it is and what it means for your portfolio.

Joining me to discuss this topic is Tom Becket, co-chief investment officer at Canaccord Wealth. Tom co-leads the firm’s asset allocation decisions and multi-asset model portfolio construction.

Tom, thanks for coming in today. 

Tom Becket, co-chief investment officer at Canaccord Wealth: Well, thank you for having me. 

Kyle Caldwell: Let’s start off with a definition of what stagflation is and why the threat of stagflation worries professional investors like yourself.

Tom Becket: Yeah. I don’t know what the exact definition of it is, but I think the way that your listeners and viewers can most understand it is a period of low growth and higher than desirable inflation.

Now, obviously, back through history, stagflation is relatively rare. A good example of it would have been in the 1970s, and there we were probably talking about inflation outcomes that were going to be, well, hopefully, much worse than they are in today’s environment, and growth outcomes in terms of recessions much more negative than we’re likely to see going forwards from here.

But really, the best way to sum it up is higher than desirable inflation and lower than desirable growth.

Kyle Caldwell: The reason why there’s concern about us entering a potential stagflationary environment is due to the conflict in the Middle East. In particular, it has increased the oil price, which in turn is increasing energy costs for consumers.

Tom Becket: Yeah. I think it’s a problem for everybody. We can talk about the root cause of it in a minute, and there’s probably immediate causes and underlying causes. But the reason it’s a problem for everybody is that people want higher rates of economic growth, people want there to be a better economic situation in terms of their pay packets, and people want the money they’re earning to go further.

A stagflationary environment affects all that, and it also makes it much more difficult for central bankers to set interest rates. It makes it much more difficult for them to support the economy. It makes decisions for policymakers, such as the government, much more difficult as well, and in terms of consumers, it probably means we’re spending more money on things which are considered stable and less money on things which are discretionary.

In short, Kyle, it’s a bit of a mess. The reason we’re looking down the barrel of a stagflationary situation here in the UK in particular - we can talk about the rest of the world if you want to, but let’s focus on the UK and be parochial for a second - is that economic outcomes in the UK at the moment are pretty measly. That’s for a variety of different reasons, but broadly, the country’s run out of money. We spent a lot of money on Covid.

There’s less ability for the government to support the economy at a time when the economic cycle is turning down and business and consumer confidence is pretty low. And without a really strong employment backdrop, the likes of you and I are not going to get significant wage increases, which means we have less money to spend on other stuff.

So, at the moment, the economic situation in the UK isn’t great, but at the same time, we’re at the mercy of fluctuating and rising global commodity prices, and let’s be honest about it, the price of pretty much everything going up. So, it’s not a great situation, triggered…as you said, by the fact that commodity prices have become unanchored because of the war in the Middle East.

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Kyle Caldwell: At the moment, it’s only the threat or prospect of stagflation. When will we know if we’re in a stagflation environment, and how long could it potentially last?

Tom Becket: I think we’re already seeing signs of a stagflationary environment. I mean, inflation in the UK is already uncomfortably high, and it’s going to go higher. And this is different from the view that we had at the start of the year, and in fairness, to our pretty useless cabal of politicians in the UK and around the rest of the world, some of this is outside their control.

The effects of Middle East commodity price rises is problematic, but we were already in a situation where inflation outcomes around the world were on the high side, and uncomfortably high in certain places, and at the same time, the economic cycle outside the US in some pockets around the world was already pretty low.

So, the UK, I’m afraid, is already demonstrating certain signs of a mild dose of stagflation already.

Kyle Caldwell: You touched on interest rates. What can the Bank of England do in terms of its interest rate policy to try and stave off this threat of inflation?

Tom Becket: I’ve been very critical of the Bank of England for much of the last few decades of working in financial markets, and I think deservedly so. But at the moment, I do have some sympathy for them, even though their communication is frankly not very good. Because what can they do? They’re not OPEC, and even OPEC can’t control the price of oil anymore because their relationships around that are fraying. So, the Bank of England is in a very difficult position.

So, yes, ultimately, they could raise interest rates, and that could potentially help slow the inflationary pulses in the UK economy. But I think inflationary spikes driven by energy prices are different to what we saw coming out of Covid. 

People will be trying to use the same playbook as in 2022, but it’s a very different situation in the UK for the Bank of England [than] it was then, even though back then, if you remember, they weren’t thinking about raising interest rates, so they got that one completely wrong as well.

But back then, the economy was strong. The labour-force backdrop was extremely strong. There was huge amounts of government money running through the economy. Wages were going up, and everyone had all this pent-up demand in 2022 because we were coming out of economic hibernation. We all wanted to do loads of stuff at the same time and buy loads of stuff as everyone else at the same time. So, the inflationary spike then was a problem, but driven by economic fundamentals.

At the moment, the inflation spike we’re seeing is really driven by one sector and one sector alone, and that’s energy. That in itself in the longer term could be quite disinflationary, i.e, if we’re all being forced to spend money on our energy bills and not on other stuff, you’ll naturally have disinflationary pulses taking place elsewhere.

For example, cinema tickets might go down or airfares might eventually go down because demand is being suppressed. At the moment, we’re just spending more and more money on energy bills and petrol.

So, look, ultimately, it’s not a great situation. The Bank of England can’t really influence it. I thought putting up interest rates here to try and quell inflation from energy prices would be a mistake and would just lead to further economic misery in the future.

It’s a difficult situation, Kyle, but I’m worried they’re going to compound the problem further by raising interest rates and killing off whatever economic activity is still existing.

Kyle Caldwell: Let’s move on to some practical pointers for investors. First, in regard to equities, of course in any scenario, there’s always winners and losers. 

If we do have this period of stagflation, will the more cyclical types of companies be more in the loser category? And in the winner category, is it potentially those that are more defensive in nature? For instance, the [latter] are able to defend price rises. They have products or services that people continually use and are not going to give up.

Tom Becket: Yeah. You could make an argument for that. But at the moment, the tale of the tape is not telling you that. Actually, a lot of those dependable, defensive growth companies are performing really quite badly. 

The first thing I’d say to investors is all is not lost. And you’re right - there’ll always be winners and losers. What we could be seeing now is the setting of the scene for opportunities to come further on down the track. At the moment, really, the market is being driven positively by two different sectors whose earnings are appreciating markedly, and that’s energy, no real surprise there, and the technology sector as well, where they’ve got this economic cycle which is taking place away from other economic cycles in the economy. They’re kind of oscillating on their own wavelengths.

Within markets themselves, though, there’s an argument to be made that staple-type companies should be performing better than cyclical companies, but I wouldn’t necessarily say there’s any evidence for that at the moment.

To your point though, if we were to see a situation where inflation remains at uncomfortably high levels for some time to come, while at the same time economic activity is suppressed because of us having to spend more money on energy bills, there is certainly the case that for things like toothpaste or staple products, we’d carry on paying for those price rises because we can’t do without it, and we would be spending less money on discretionary outcomes.

So, there is very much a case - if this carries on for quite a long time - that we could be in a situation where defensive, dependable companies start to be rerated, and cyclical companies are left behind.

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Kyle Caldwell: In that scenario, would you be more likely to favour the more growth-focused fund over a value-focused fund?

If you look at the returns over five years, a number of value funds have performed very well. So, the likes of Temple Bar Ord (LSE:TMPL) investment trust, Artemis Global Income I Acc (B5ZX1M7), and some of the ones that focus more on high-quality growth companies, they have underperformed quite markedly compared to those value styles.

Tom Becket: Yeah, there’s a case to be made for that. I’m not sure it’s as clear-cut as that, in all honesty. Some of those growth companies or funds focusing on growth companies have underperformed because the starting point was simply too high, and we’ve seen a rerating of those companies lower.

Arguably, you could say they’ve started to become more attractive, but at the same time, what we’re seeing in markets at the moment is a repricing of some of those old economy stocks, which has led to this value-driven recovery, and I think given where starting valuations are, there is a case that that could continue.

So, over the last few weeks and months since the start of the year, there’s continued to be a rotation towards areas of the value parts of the market, and typically when they start, they do carry on for a couple of years. So, I think it’s too early to tell that. 

In answer to your question though, we are going to see a great deal more bifurcation between winners and losers in various different sectors, and I think we’re also going to see pockets of really quite extraordinary volatility. I mean, we’ve seen that for the last few years, haven’t we, Kyle?

Last year, the technology sector started the year really badly, collapsed into April, then had one of the strongest-ever recoveries on record, and in recent times, we saw the technology sector perform very poorly in March before having a Lazarus-style recovery in April and early May. I think that’s an indication that there’s lots of volatility going on.

Having too much betting on one theme, sector or style in particular would probably be the mistake, but we should expect that bifurcation to be creating opportunity for us all. 

Kyle Caldwell: So, the key ultimately, as ever, which we talk about a lot on this podcast, is being diversified, including being diversified in terms of investment style?

Tom Becket: Yeah. I would say so because I don’t think there’s a really obvious way to spot good value at the moment.

I would say that markets generally are full but fair, but some of the extraordinary valuation discounts that we’d have seen in things like the value sector a few years ago, they have undoubtedly narrowed in the last few years.

One of the ways you can best see that is the fact that the UK FTSE 100 has been one of the world’s best-performing indices, and that’s quite value orientated, quite old economy, etc, and the fact that that’s really performed well in the last few years tells you that some of that valuation discount for value has narrowed.

So, at the moment, in particular, given there’s no obvious screaming value opportunities, it is a case of being really quite diversified and quite balanced.

Kyle Caldwell: In terms of bonds, inflation, of course, is the enemy of bonds as it erodes the purchasing power of the income that bonds generate. What’s your outlook for bonds in a stagflation environment?

Tom Becket: Well, the simple fact to mention is that yields have gone up. That is good. The second point has to go down to how long you think this stagflation episode might last, and how bad might it be.

The good news is, and you rightly point out that inflation is the enemy to bonds, it’s sort of like kryptonite was to Superman, it has the same effect on bond prices, but ultimately you just have to look at where yields are now and try and work out whether that’s good value or not. 

Let’s take the UK 10-year gilt, which at the moment is trading about 5.1%. It’s been around that level for a while, and ultimately that could well be the price for some time still to come. So, 5.1%, and you know that every single year you’re going to be paid 5.1% from owning that 10-year UK government bond.

Now a lot might happen in the next 10 years. If I’d have told you back in 2019 what would happen over the next seven years, it might have tested our friendship through the threat of incredulity because we would never have predicted what’s happened in the last seven years. So, 10 years is quite a long time to predict.

But ultimately, if you think about it as a mathematical contract, you know you’re going to be paid 5.1% per annum for holding that bond, OK? So, what’s your inflation expectations during that period? Well, in the last decade, inflation struggled to get above 2% really. That was kind of the ceiling on inflation. My suspicion is the old ceiling is now the new floor. Inflation is not going to fall below 2% on an average basis for some time to come in the UK in the future.

So, let’s just put a premium on top of that in terms of inflation and say could it be 3%, 3.5%? Among friends, let’s say it’s 3.5% on average for the next 10 years. But if you’ve a bond that’s paying you 5.1%, you’re making a real return, a return adjusted for inflation, of 1.6%, which means the value of your investment now will be worth what it is in the future, the same as in the future, therefore the same in the future, but with 1.6% on top of that per annum.

That’s not a disastrous situation to find yourself in, and in particular, go back to the end of 2021 when I was just about as negative [on] these investments as anyone you could find in the industry, the yield was zero, and inflation rates were about to go much, much higher. In fact, they got above 10% in the UK. This is a very different starting point in terms of being rewarded, or suitably compensated, for investing in bonds.

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Kyle Caldwell: We’ve seen lots of demand from customers for low-coupon gilts over the past couple of years because the [potential] returns on offer are really attractive, and also there’s no capital gains tax to pay. What should people think about in regards to whether to consider a low-coupon gilt over a gilt with a much higher coupon?

Tom Becket: It would depend entirely on your tax circumstances. So, if you’re going to buy a gilt for your ISA or SIPP portfolio, it doesn’t really matter one way or the other.

In fact, you would buy a high coupon bond because the tax efficiency plays in your favour because ultimately the lower coupon bonds are trading slightly more expensive than the higher coupon bonds with similar maturities because people are using the lower coupon bonds as being tax efficient. It’s not a huge amount of difference, but there is a difference.

So, if you’re using an ISA or a SIPP, I would just simply look for the tax efficient. Or if you paid no tax elsewhere, then again you can consider the higher coupon bonds, they’re probably slightly better value.

But if you’re using money which is taxed, and you’re a higher-rate taxpayer or a highest-rate taxpayer in particular, the opportunity set is absolutely still there. 

You could argue that it’s even more attractive now than it was beforehand because we’ve gone from a situation in short-dated bonds where there were two interest rate cuts expected by us and by the rest of the market, including one in March, where obviously that didn’t take place. Now forget the two interest rate cuts. Markets are factoring in three interest rate hikes between now and the end of the year.

Well, as per our earlier conversation, if the Bank of England does that, we’ve got big problems from an economic perspective, and I suspect interest rates to be a lot lower in a couple of years’ time if they did that. But in terms of the effect on short-dated bonds, what it’s meant is that your yield opportunities become more attractive.

So, at the moment, you can get a roughly 5%-ish type return from a low coupon short duration bond, which if you were to round that up to a tax equivalency, if you’re a 45% taxpayer, is somewhere around eight and a bit percent.

Well, if you look at the wealth management industries, net returns over the last 20 years on an annualised basis, it’s about five and a bit percent from a portfolio that’s got 60% in equities. So, actually, this is still a really good opportunity to invest money in a tax-efficient way, and get money which is relatively risk free.

Kyle Caldwell: Of course, there are lots of different types of bond funds out there as well. But given those potential returns that are on offer, I suppose a lot of people might take the view that they don’t need to necessarily own a bond fund if they’re willing to go away and do the homework, the research, and learn about individual gilts?

Tom Becket: Yeah. Totally. But it’ll depend on the person watching this video or listening to the podcast to make their own decisions on that basis. 

Bond funds can be relatively complicated, and bond maths is something that you do need to do a bit of research on. But you should be able to find lots of information written about these sorts of bonds, which will make it easier to understand.

Ultimately, I just want to point out why we remain a bit more optimistic than perhaps the current market environment would suggest, and I want to take you on a brief history lesson. If you go back to the end of 2021, when perhaps our PR department was less keen to put me on shows like this, we’re talking about a situation where it was really quite hard to make money.

You had bond yields in government bonds that were 0%, as mentioned previously, but in fact, that was actually not a bad return by comparison to $18 trillion worth of bonds around the world that had a negative yield.

Someone watching this might say, what on earth is a negative yield? That’s when you pay someone for the privilege of lending them money.

The yield you’re getting is less than zero, and people look at that and think that’s just completely crazy, but that’s where we were at the end of 2021.

If you want to take a bit more risk and invest in a high-quality corporate bond, you might have got a return of somewhere, based on the UK index, of about a 1.5% annual income payment. That’s almost nothing. And ultimately, after the various different fees of platforms and funds, that is probably nothing. If you adjust it for inflation, it’s worse than nothing, but let’s not go there.

If you wanted to take a lot of risk in bond funds back then, you could probably get a return between 3% and 5%, so we’re talking about the lowest yields ever in history.

Well, as we sit here today, those equivalent yields are almost 5% for a government bond, 6% for a corporate bond, and if you take some risk in fixed interest, you can find equity-style returns of 7% to 8%. So again, I appreciate it’s difficult out there. The environment is challenging, there is the threat of stagflation, there’s the threat of pretty much anything this year, Kyle, let’s be honest about it. But ultimately, the mathematics are starting to work in your favour.

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Kyle Caldwell: I also wanted to ask you about alternative assets. In terms of potential hedges against inflation, the one that’s most often touted is commodities. What’s your view on that? I mean, they have historically proven to be a hedge, but it’s not always the case that when stock markets are volatile, assets like gold will necessarily protect you. I mean, we’ve seen that early this year - it didn’t play out for gold. Gold didn’t prove to be a defensive asset in that scenario.

Tom Becket: No. If you don’t mind, I’m going to separate broad commodities and gold into two separate stories because I think they are now separate stories. 

You’re right to say that commodities are not always protective in market downturns, and a lot of this just depends on what the market downturn actually is.

If you go back to 2008 as an example, the really big financial crisis that I worked through, bonds performed well, equities performed poorly, and commodities performed poorly because that was an economic shock, a depressing economic factor with no real positivity, and so then therefore, with no economic growth, commodity prices came down quite considerably.

2022, another big market shock. Bonds went down aggressively. Equities went down aggressively because interest rates were going to have to go up aggressively. But because of the nature of the conflicts in the war in Ukraine, commodity prices went up very significantly because it was an inflationary shock, and the prices of all commodities went up.

There is a reason behind this history lesson, and we’ll get into the present state now, and that’s that in the situation that we’re in now, as the situation we’re seeing is once again inflationary, and economic growth around the world is measly but not disastrous, and commodity pressure points are appearing everywhere, commodity prices are appreciating at the same time as we’re seeing bonds under pressure and equities being quite volatile.

So again, it goes down to the nature of the shock. You can’t always predict that commodities are going to do well in these situations, but if your concerns are about greater inflation, then commodities are a diversifier.

But a lot of your watchers and listeners would say, well, hang on a sec. My positions in gold this year started really well and have gone really bad recently. So, the gold price went from $2,000 a few years ago when no one liked gold, no one cared about gold, to $5,500 when everybody loved gold and there was a huge speculative mania. 

I heard that gold became the new bitcoin apparently, which probably tells you [to be] slightly worried about the level of speculation when you get to that point. Then, when we started to see the war in Ukraine, we saw a major pullback in gold from roughly $5,500 to $4,500.

To your point, it did no protection whatsoever. In fact, the biggest surprise through the whole Iranian war conflict has been the poor performance of gold.

But I think it makes sense because ultimately, gold has gone from being a safe-haven asset to more of an asset of speculation. Therefore, when people started to take less risk, the gold price sold off because people sold gold to perhaps try and cover their losses elsewhere, while the energy prices performed particularly well. 

So, in our portfolios, we are keen proponents of broad commodities. I particularly like the energy complex. I really like industrial metals, and I’m very positive on soft commodities.

At the moment, I’ll be a bit more neutral on gold because it’s no longer got the real speculative throes that we saw a few weeks ago, or a few months ago, but I think at the moment, there’s probably still that can get more washed out. And I think we get better inflation protection in the stagflation environment through broad commodities.

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Kyle Caldwell: I wanted to end by asking you for final thoughts on if you had clients who came to you and said they were really concerned about the threat of stagflation. What would you say to them?

Tom Becket: Well, I would probably take them on a journey through the turbulent twenties so far. If you think about the last seven years and everything that we’ve dealt with and have had to invest through, again, if you’ve made those predictions in 2019, people would have thought you were crazy. And ultimately, through this decade, despite the best efforts of central bankers, politicians, and various other geopolitical lunatics around the world, you’ve ended up with similar returns to that which we saw in the previous decade, just with a lot more volatility.

I would just say to people that, yes, the threat of stagflation is high, but not all is lost. There are plenty of ways that you can protect your portfolio against stagflation, and in the volatility that we’re being presented with, you should treat it as a friend, not an enemy. Volatility breeds opportunity.

I like it when the stock market goes down 10% to 15%, not because our clients get in touch being very happy, but more because it’s creating the seeds for the next round of opportunities in markets, just like we saw in 2022, like we saw in 2018, like we saw in 2008. Know, this will breed opportunity.

So, in our portfolios, you look at them now, I’m very optimistic on the outlook for inflation-linked bonds. I like the yields that we’re getting on government bonds. I like the yields we’re getting on broad bonds. I like commodities. I like things like mortgage-backed securities. I like areas of the equity market which are still offering quite diversified inflation-backed opportunities such as utilities, infrastructure and healthcare. All those sectors look to be quite good value.

So, I would say to clients that a broad diversified approach is right. There are opportunities in financial markets to protect against stagflation, and I would have embraced those investments, which are already starting to price in that stagflation environment.

Kyle Caldwell: Well, Tom, when it comes to my investments, as you know, I’m quite a bearish outlook. But I think after our conversation there, I’m now a little bit more optimistic.

Tom Becket: Well, as you know, by leaning, I would also be quite bearish. I think ultimately, it does pay to be protective of clients’ assets. But at the moment, I think you have to be honest. There’s a lot of bad things going on out there, but there’s lots of ways to benefit from it as well.

Kyle Caldwell: Well, thanks for your time today, Tom.

Tom Becket: Thank you.

Kyle Caldwell: So, that’s it for our latest episode of our On The Money podcast. We always love to hear from listeners. If you’ve got an idea of a future topic you’d like us to cover on the podcast or you have a question that you’d like one of the team to answer, then do get in touch by emailing: otm@ii.co.uk.

In the meantime, you can find plenty of analysis related to funds, investment trusts, and ETFs on the interactive investor website, ii.co.uk.

Hopefully, I’ll see you again next Thursday.