PORTFOLIO STRATEGY IN THE NEW ECONOMY

6 October 2021

"Weather the expected downturn and wait for stability to return."

Question about strategy in these times of crises and change and in particular, how to deal with inflation.

We may be entering a very different economic environment. Just had an email from a reader who is a Royal Bank of Scotland pensioner on a company pension. 

He was surprised to learn that their annual increase whilst tied to inflation is capped at 5%. How many other pension schemes will be like that? Any prolonged period of inflation above 5% is a disaster for them.

Quote:

"Money markets are predicting that price rises will run far ahead of the Bank of England's expectations by next spring as Britain is gripped by worker and material shortages. Investors are predicting that the Retail Price Index (RPI) will soar to 7pc in 2022, hitting its highest level since the 1990s. A jump this high would put a huge squeeze on living standards and spark fears of runaway prices with severe economic consequences."
https://www.telegraph.co.uk/business/2021/10/06/markets-bet-inflation-will-hit-6pc/

Could competition from any new higher-coupon gilts threaten the capital value of dividend stocks?

What should we be thinking about for our portfolio?

EVOLVING ANSWER...

Does look as if we are potentially entering a very different economic environment. Boris talked this morning of a high-skill, high-wage, high-opportunity economy, for carers and entrepreneurs. But no mention of debt, inflation nor interests.

We arguably managed to sail through the global financial crisis of 2009 with little real economic damage by loading up on government debt. Ditto for the pandemic, only on a much larger scale. 400b is a lot for the UK to repay.

But will it repay at today's exchange rate? Or could the plan be to let inflation burn off the debt?

The magic money tree has likely run out, and rates are already effectively up against the zero lower bound. It seems more likely that the government will want to raise taxes and cut spending going forwards, and that's what it's started to do. Can it contain inflation?

Supply chains all over the place are at or beyond breaking point, labour shortages and  unmanageable energy price changes.

But that's not all. Take food prices.

Poor harvests in Brazil, which is one of the world's biggest agricultural exporters, drought in Russia, reduced planting in the US and stockpiling in China have combined with more expensive fertiliser, energy and shipping costs to push prices up. Food producers will all be affected and will therefore all be raising prices in similar ways because it's so widespread that everyone will do it without risking losing customers.

Commodities, a similar story. Again, is it temporary while supply and delivery are re-configured; or is a permanent feature ? Are we entering a new supercycle?

It looks a lot like the aftermath of world war two! Huge amounts of government debt and an economy that had literally been blown to bits.

Of course, the situation isn't anywhere near as bad as it was in the late 1940s, but I wouldn't be surprised if we end up with a very weak UK economy for a couple of decades as people are squeezed between insanely expensive living costs and stagnant wages (as rising wages in the absence of productivity gains only make the case for offshoring and automation stronger, with lowest-paid often immigrant thrown to the dole at taxpayers' expense).

But we need an economist, so until we find one, take these views with a large dose of salt.

In terms of individual stocks, the best insurance against a weak UK economy would be to invest outside the UK, so that's something to keep in mind. The FTSE 100 is a good place to find companies with international earnings. 50% international minimum and  wouldn't want it to go much below that.

If looking for sectors, energy stocks, consumer staples and equity-based real estate investment trusts (REITs) have historically survived inflation best. But history may not be a guide when you have supply-chain disruption and city REITS are down from covid WFH. Utilities are regulated and going bust. Try funds and trusts with a strong brand and clear strategy but as we know over 10 years only a quarter will beat their indexand of course we dont know which quarter.

As for rising bond yields impacting dividend stocks, this seems likely. However, much of that risk can be offset by investing in stocks that are already on low valuations with high yields. The very popular and very highly rated dividend growth stocks would be much harder hit if inflation and rates do go up materially.

So continue the hunt for low PE high div stocks and maybe treat this as a satellite ETF in the core-and-satellite strategy we presented earlier.

Or go for a globally diversified portfolio with a mixture of equities and high-quality bonds bonds providing stability and equities providing the growth to beat inflation. Ramin again

https://youtu.be/jKMZOojV0mE

It may not lend much immediate comfort, but in the long run it could prove to be the wisest choice: lower expectations, aim not to lose against inflation, ie weather the storm for now and wait for stability to return.