Part 2: Inflation Raises Its Head


While today’s “Goldilocks” economy may be just right to generate ample returns for now, we’re nearing an inflection point, and the investment strategies that excelled in recent years won’t do as well going forward.

Supply chains have already seen their input prices, things like copper and lumber, take a jump. CIO Rob Edel discusses this further in Part 1. On the demand side, the combination of reduced household spending and government relief since the pandemic broke out enabled American consumers to save US$1.8 trillion.

There’s a lot of pent-up demand in the market that, as the economy reopens, is going to be released,” Edel predicted. And with the Biden administration embarking on an unprecedented stimulus spree—what economist Larry Summers, himself a Democrat and Keynesian, called “the least responsible economic policy in the last 40 years”—rising prices will likely soon take hold across the economy.

Edel doubts the additional government spending will be temporary, either. The U.S. Democratic Party sees stimulus as an opportunity to change the government’s role in the economy, and even should Republicans retake one or both houses of Congress in the 2022 midterm elections, they won’t want to be the party pooper and cut spending.

Investors should not fear this new era of rising inflation and interest rates, Edel said. But the growth stocks that have outperformed for a decade now are sensitive to interest rates and will suffer. The chief beneficiaries of this rotation to a higher-inflation environment have traditionally been energy, materials, financials, industrials and real estate equities. It should be a good time for the S&P/TSX Composite index, which is weighted 73.4 per cent to these cyclical or value sectors, compared to 29.2 for the S&P500, he observed.

We aren’t saying sell your U.S. stocks. The U.S. market is incredibly deep and dynamic,” Edel made clear. “But you may want to rethink a passive index approach.

Perhaps the biggest risk to a higher-inflation environment falls on the fixed income side. During the low-inflation environment of the past two decades, he noted, equity prices have been correlated to bond yields, meaning bond values rise when stocks drop. But during the high-inflation era from 1970 to 2000, that correlation disappeared.

If you think inflation is going to go above 2 per cent, the old 60/40 portfolio mix—60 per cent stocks, 40 per cent bonds—won’t work, Edel advised. You can no longer expect bonds to protect you from stock market volatility. “You don’t want to hold just stocks and bonds,” he warned.

The best inflation hedges have historically been gold and commodities. Unfortunately, these non-income-producing assets make impractical substitutes for fixed income. Other hard assets, however, such as infrastructure and real estate, have the ability to reprice their revenues in the face of inflation and so can act as a bond replacement.

What you don’t want to own in a time of higher inflation are assets whose net present value is based chiefly or entirely on their terminal value—their price on the imagined date you sell, usually far in the future. Inflation will erode the value of that distant payday.

“You certainly don’t want to own an asset where you don’t know what that terminal value is,” Edel added, pointing to the example of the cryptocurrency Dogecoin, which was “created as a joke” but nonetheless hit a market capitalization of US$50 billion earlier this year. Worse still are leveraged investments, he said, citing the US$20 billion collapse of the Archegos fund, mostly invested in tech stocks, over just two days in March.

Returning to his theme on the state of the economy, Edel concluded, “We think the left-tail risk [the possibility of a COVID-19 resurgence] has been eliminated.” That leaves markets in a benevolent “Goldilocks” phase, wherein equities are expensive but should still generate positive returns as long as interest rates stay low.

“Inflation is the big debate we see right now,” Edel said. He noted during the question-and-answer session following his presentation that his research file was overflowing with articles about the possibility of inflation. Sooner or later, he added, “we think it’s going higher,” which means investors should be rethinking their portfolio construction.

A big part of that portfolio rebuild means reallocating funds to real assets and private equity, the subject of Nicola Wealth chairman and CEO John Nicola’s presentation at the 2021 Wealth Summit, which we’ll be covering in our next instalment.

Watch the full 2021 Strategic Outlook event on April 28 here.

This material contains the current opinions of the author and such opinions are subject to change without notice. This material is distributed for informational purposes only. Forecasts, estimates, and certain information contained herein are based upon proprietary research and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. All investments contain risk and may gain or lose value. Please speak to your Nicola Wealth advisor for advice based on your unique circumstances. Nicola Wealth is registered as a Portfolio Manager, Exempt Market Dealer and Investment Fund Manager with the required provincial securities’ commissions.