26 February 2021 | Paul Dixey

The Art of Investment Podcast: Should we worry about inflation

In this first episode, Paul Dixey talks to Simon King, CIO of Vermeer Partners and Tim Gregory, Fund Manager of the Vermeer Global Fund about the threat of rising inflation and what we are doing with portfolios to protect against this risk.

We’ve created this podcast series to shed light on some of the topics running hot in the investment community today. With insights from industry experts in their own Golden Eras, we reveal some of the issues investors face in today’s often complex, investment world. Whether you are a seasoned industry professional or an enthusiast beginning your investment journey, we hope you gain some valuable insights and enjoy the series along the way.



Read the full transcript below

Key Points

• 00:05 Paul Dixey:

Welcome to the first episode of The Art of Investment. I’m your host, Paul Dixey - Investment Manager at Vermeer Partners. And I'm delighted to be joined today by Simon King, CIO and Tim Gregory, Lead Manager of the Vermeer Global Fund. So today we'll be answering the hot topic of should we be worrying about inflation. And within that we'll be covering a few things, but mainly the huge stimulus packages being put together by central banks and governments across the world, the impact that these extraordinary measures may have on inflation in the global economy. And finally, how we as investors can protect our investments against the threat of inflation and possibly rising interest rates. So Tim, Simon, I'm a little bit wet behind the ears, all I've really ever experienced since I've been working in the industry is very low inflation, very low interest rates. With talk of negative interest rates in the UK here, maybe we can just touch on why we've been in the state of low inflation and low interest rates for what seems like forever. Simon, I was wondering whether you want to take that one?

• 01:51 Simon King:

Very interesting question - as you point out, it's decades since we've seen any meaningful inflation and it means most market participants. And indeed consumers have grown used to very low levels of price increases and have got into a mindset where they just don't expect prices to go up. And it is literally back to the 1970s since we last saw a decent period of inflation. Unfortunately, it grew to be a period of hyperinflation. So just to remind people, we were talking about inflation rates at 25%. And it took a pretty bold move by the then Chairman of the Fed Paul Volcker, with a series of very aggressive interest rate rises, to curtail that and effectively put the economy into recession. So that's why people fear it. And as I say, we have a large group of the population that don't really know what it looks like, and indeed, how you go about dealing with it…

• 02:50 Paul Dixey:

And so, essentially, since the financial crisis, central banks have been doing extraordinary amounts of quantitative easing, whether it's been printing lots of money and buying long term bonds to keep borrowing costs low for both consumers and businesses. Obviously, this has fed through to incredibly low inflation and low interest rates, so what should we be thinking about here? And are there other long term, deflationary drivers that may be in play that have kept prices for so low for so long?

• 03:20 Tim Gregory:

I think that is right, there have been a number of factors at play since the financial crisis in 2008-09. Now, we've been in a very, very shallow cycle, low growth, low inflation, what people dubbed at the time “the new normal”. And alongside that, there has been the significant technological revolution that we've seen over the last 20 years, that has also had a significant impact on labour inflation. There's a different debate going on now about what is happening, post the tragedy of Covid, and all the stimulus that we've seen: - the long-term structural issues, that technological innovation has created; increased robotics; those sorts of things have been a big factor alongside this period of low growth and a period of almost no optical inflation that's impacted the interest rate cycle. So we were used to a boom and bust cycle of interest rates rising as inflation rose, and then Central Banks tightening policy very aggressively and putting rates up to curtail inflation, forcing the economies into recession and then restarting the cycle. And we got used to that, and that cycle has been taken out of the equation to a degree, post 2008-09, by the measures that the Central Banks have put in place with quantitative easing, to suppress interest rates and in part to suppress the economic cycle.

• 05:04 Simon King:

So that's, that's a really important point. And because we are now in uncharted territory, as far as the economic situation is currently. We've had this unprecedented amount of monetary stimulus, quantitative easing QE, as it's become known. And we've had unprecedented levels, also a fiscal stimulus, ie governments with all sorts of schemes from furlough through loans to small businesses, etc. And what that basically means is that we know the economy and the Central Banks have printed a lot of money.

• 05:47 Tim Gregory:

There's been a suggestion hasn't there that, that as much as 40% of all the dollars that have ever been created, have been created in the last year, because of the unprecedented situation that we're in. And, the fact is, almost none of the quantitative easing that's been put in place since 2008-09 has been withdrawn. So it is massive stimulus on top of an enormous amount of money that has been printed over the last 10 to 12 years.

• 06:25 Paul Dixey:

And just on that, I think what is quite interesting and what is clearly grabbing investors’ attention now, is that governments seem to be acting in line with Central Banks, which perhaps hasn't happened in the past. So obviously, we've got the continued QE but now, governments are getting involved too.

• 06:45 Simon King:

That's absolutely right they are working hand in glove at the moment, and their interests appear to be completely aligned. And that's certainly an important driver in the markets, because as soon as markets wobble, there's a statement from either the Fed in the US or some of the other Central Bank authorities, or indeed someone in government to basically say we are unwavering and we are going to keep going with the current policy. But one of the other major issues is that, a lot of this stimulus has not really found its way to the places that was intended. So it was there to reflate the economy, to get to businesses, to get to consumers and get them spending. Unfortunately, a lot of it has been funneled off into the financial markets, hence, you've seen most asset classes perform very strongly, because the money's not going to the right people. They're saving it rather than spending it and a lot of those savings are finding their way into financial markets. So you've seen equities, commodities, cryptocurrencies, bonds, virtually everything performed very strongly in the last couple of years.

• 07:53 Paul Dixey:

And it leads us nicely on to what Larry Summers, the former Treasury Secretary has been saying. He's worried about the overshooting, so let's, have a listen to what he said - the audio is from Bloomberg TV.

• 08:09 Larry Summers, courtesy of Bloomberg TV:

This is probably the boldest economic proposal since the Great Society and perhaps the boldest economic proposal since the New Deal. And so I don't think the right question is whether this package would overheat the economy. I think if it were passed, as written, it would overheat the economy. But will this shift the debate towards our doing more? Will this shift the debate towards doing more for those who've been left behind? And I think the answer is, yes. But we are going to have to watch this economy very carefully. And I do think the conventional wisdom is under-estimating the risks of hitting capacity. And if we do anything approaching this, we are going to be managing the economy with the accelerator more on the floor than at any time in peacetime history.

• 09:18 Paul Dixey:

So Tim, we’ve just heard there Larry Summers. He's clearly very concerned about the potential overheating of the economy, this being the boldest economic proposal of perhaps a generation. It seems like you're very much in his camp, in terms of being worried about rising prices.

• 09:37 Tim Gregory:

So I think Mr Summers is pointing out the scale of this package, on top of the stimulus that's already been provided. As I said, I believe that the stimulus already provided has been absolutely necessary to help bridge the economy through what has been a completely unprecedented economic situation of lockdowns and lost jobs. But as I said, earlier, I think that the pent-up demand in the economy and a package of this size does create the potential (because, we do have this output gap that has to be filled, but the money that's been talking there does create the potential) for us to see inflation in a way we haven't seen it for a very long time. And it could be leading to a new era for us as investors that we haven't seen for ages. Simon was pointing out that everything has been performing well, maybe government bonds are starting to not perform well. And , interest rates at the longer end are rising, because investors and Wall Street are beginning to sniff out the risk of inflation and that has had some impact on long duration type growth stocks. Already there has been a big rotation back towards value type parts of the market. And part of that, of course, has been what we call a re-focus to the re-opening trade: companies that are going to do better as a result the economy normalizing. But that may bring with it some inflation risk, in a way we certainly haven't seen in the post financial crash era.

• 11:17 Simon King:

The fear of the markets, as we sit here today, is that once they let the inflation genie out of the bottle, can they continue to control it? Because as , the savings rate has gone through the roof in the last couple of years, there's a huge amount of pent up demand for things like holidays and eating out as a huge monetary stimulus and as a whole huge fiscal stimulus. If that all combined, as we come out of lockdown - in most of the developed economies at the same time, as they're being some supply side issues, in terms of companies taking a little longer to get back to full production etc, then you have the very real prospect of a big overshoot in terms of inflation. The numbers will look horrible short term anyway, because they remind people, inflation is a rate of change, usually on a 12-month basis. And as we cycle into the comparatives of March last year, when things were obviously very weak, then inflation is going to look big anyway. Central Banks and governments will say, well, that's fine and we'll wear that for the short term, but then as the we see stronger numbers that will come down. That is what the market is starting to fret about. And quite rightly, in our view.

• 12:32 Paul Dixey:

And I guess also on that, although Trump now is no longer in the White House, there was a lot last year on protectionism, restricting imports and trade friction etc. I guess that isn't helpful for inflation either.

• 12:47 Simon King:

No, undoubtedly one of the big impacts on the sort of deflationary aspects we've spoken about, endured for the last couple of decades has been globalization. And , the access of developed economies to vast pools of cheap labour in underdeveloped economies. Well, demographically, and just economic growth wise, that story is starting to slow. It will slow slowly, but things like, the protectionism, you mentioned, will accelerate that process. So some of the deflationary factors we've seen over the last couple of decades could well start to at least slow, possibly even reverse.

• 13:26 Tim Gregory:

That's all true from a sort of globalization perspective on labour. But I think, adding a point that we were making earlier, the impact of robotics, factory automation, artificial intelligence, the impact that that is going to have on the labour market over the long term, set against these inflationary pressures that we're talking about, in the long term structurally, there are still some issues there that I think are going to suppress long term inflation. But we're dealing with two things here. We're dealing with the short term impacts of this colossal stimulus that we've seen, set against those deflationary factors, albeit as Simon says, the way that globalization has shifted, and the labour rates have changed somewhat in all parts of the market. So, I still think that there are some structural deflation impacts out there, albeit not as great as they were previously.

• 14:26 Simon King:

That's a great point, Tim. Because the market and the general population is in uncharted territory here. In that, there's a short-term upward pressure on inflation, but many of the long term deflationary aspects are still very much there. So you're asking the market to take a sort of split view if you like on short term inflation and long term inflation. And although markets should undoubtedly be sophisticated enough to manage that, that's not always the case.

• 14:54 Paul Dixey:

So it leads us nicely on to, the other side of the argument, which is what Janet Yellen, current Treasury Secretary is talking about at the moment, she doesn't seem to be as concerned about hyperinflation. And we've got a clip here now of her.

• 15:14 Janet Yellen, courtesy of Bloomberg TV:

I'm afraid that the job market is stalling. We saw that in Friday's employment report, we're in a deep hole with respect to the job market, and a long way to dig out.

• 15:30 Paul Dixey:

She's not that worried. She's also supported by Jay Powell, who says there's lots of slack in the economy, in the job market, unemployment could be higher than is currently being shown due to job support schemes etc. Is this another thing we need to be considering?

• 15:50 Tim Gregory:

Most definitely. And there's two different arguments here. There's absolutely no question, that the unemployment levels are high, and support schemes, have kept people in work. But, the question is, are these policy decisions going to ultimately be what we call behind the curve, because obviously, they reflect where we are now. And we're just about to layer in another colossal amount of stimulus. And, that could have us much more returned to normal, hopefully the vaccines work, let's hope we can get towards a normal life, whatever that might mean. And so it's very much our job to look forwards and try to assess what's going to happen next. Hopefully, what we're going to see is a return to normalization, there will be a lot of job creation, jobs that have been lost in the service sector will be returned. So there's no dispute about the fact there is a lot of slack in the economy at this point in time, but the question remains for me, what will this look like in the second half of this year, at a time when all this spending, that is the pent up the demand for holidays, for trips, the restaurants we talked about earlier, all these things are still to come. We are currently just emerging in the UK, because we've done very well with the vaccines, from the lockdown. So it's very hard to work out what that picture is going to look like, as we come out the other side.

• 17:24 Paul Dixey:

Say Larry Summers and his concerns are proven to be correct, and we do get some inflation in the system. Why is inflation bad? I always thought that a little bit of inflation is probably quite good for stock markets and for the economy, but I guess hyperinflation is not. Simon, you mentioned the 1970s. Now I wasn't even thought of then, I'm wondering whether either of you were around. And perhaps you can sort of tell us why hyperinflation is bad for bad for individuals and bad for the economy.

• 18:01 Simon King:

Well I was quite young in the 1970s and certainly remember the price of sherbet dib dabs going up quite extensively. It's just the uncertainty that it really presents. And it basically means people are getting poorer and can get quite markedly poorer when rates are at 20% or 25%. But even at 10% if your earnings are only going up at 2, 3 or evn 5% then you are getting progressively poorer and at quite a quick rate. And on the flip side for anyone who obviously holds debt, and this is something I think a lot of people don't really remember or realize, is inflation is good news for you, in that it deflates your level of debt, and that your nominal level of debt, your mortgage predominantly, doesn't rise. But if your house price is going up at a rate even close to inflation, then your equity in that house is obviously increasing quite significantly. So it is good news if it's steady and persistent over a long period of time. But in terms of the level of uncertainty it produces in the economy, if there are short term bursts or overshoots, then that can be extremely damaging to economic performance.

• 19:14 Tim Gregory:

I agree entirely with Simon's points. And he obviously shared the same penchant for sherbet dib dabs as I did, I remember my pocket money definitely did not go up fast enough to cover the cost of that and the price of gobstoppers as one dentist keeps reminding me. So I think the other point it's worth reminding ourselves of is obviously, a lot of people have fixed rate mortgages and people have variable rate mortgages. So it’s absolutely right for Simon to point to the that fact that some reflation will help to reflate debt away. But obviously, if inflation gets out of control, and we do return to a boom/bust type cycle - short interest rates have to go up and mortgage rates go up because we move into a period where interest rates are very different to how they've been structured for a very long period of time - that could lead to some pain in the housing market, because mortgage servicing could be very different ballgame. As fixed rate mortgages come off and become either variable or have to be fixed at new rates, that could take quite a lot of money out of the consumer’s pocket going forward. And that would be unhelpful to the economy. So it's far too early to be talking about that at this time. But these are all the things that we have to think about what might happen, if we did have a return to a more normal inflation, or an old fashioned inflation cycle. What is normal these days is a different question altogether and the new normal has been an era of low rates and low inflation, structurally for a very long time.

• 21:02 Simon King:

And I think the other thing I'd add to that would be that we tend to look at things with a very financially driven prism, but we should remember that high inflation tends to hit the lower echelons of society a lot harder than it does the richer. So it can be extremely socially divisive and create political instability. But that's also something that's got to be factored in.

• 21:28 Paul Dixey:

And talking about political instability, the other thing I guess, we’ve got to think about at some stage is how on earth we're going to pay for all of this debt that we'll have accumulated. I think the US national debt pile now is twice the size it was when Obama was in charge. How are we going to pay that back? I guess, the real key here is to make sure that when governments do spend a lot of money, that the money they spend is invested well, and they get a return on their investment, because otherwise, we could potentially end up in a sort of Japan style 1980s and 1990s type event.

• 22:06 Tim Gregory:

In many ways, that is the ultimate question that faces investors, and has been, consistently pushed down the road by everybody. I don't think personally, Central Banks and governments know themselves the answer to those questions about how we're ultimately going to get out of all this money printing that they have done. And obviously inflation to a degree would help that. And unfortunately, and as a caveat to that, the Coronavirus situation has forced unprecedented measures that were necessary this time last year to keep things going, whether history will judge that they've made the right decisions or not time will tell. But I simply don't think that people actually have the answers to those questions. At the moment, I'm sure Simon is now going to give us the answer to that question, and make me look a fool! But, I actually think that the authorities don't know the answers to those questions themselves.

• 23:20 Simon King:

No I'm not. I entirely agree that that issue has been kicked entirely down the road into the long grass, call it what you may, everybody realizes it's the elephant in the room. But as Tim says there are other things to deal with in the short term. Ultimately, there's only two ways out there: as Tim says, a bit of inflation, exactly the same principle as the mortgage on your house, in that you deflate your debt over the very long term; and then the other factor is there would have to be an increased tax take. And there's two elements to that also, hopefully they reignite economies to grow, and therefore tax goes up. But they will have to look to collect more tax from the existing economic base. But again, I don't think any government has got the stomach for that in the very, very short term. So I think that will be an issue for 2012 and beyond.

• 24:13 Tim Gregory:

And that's a really important point, because of the short term debt or the short term and long term debt that's been taken on, how authorities are going to respond to that, from a taxation point of view is very important in terms of the balance between growth and moving us away from the crisis - because it would be, in my view, a mistake to increase tax to try to pay for this in the short term and choke off demand. Now, I would much rather see, to this point of the output gap and job creation … fiscal stimulus targeting, for example, infrastructure investment, whether that be digital or physical infrastructure, to improve water quality, to create real jobs and that those jobs then put people back in work, that people pay tax on their income, but have the ability to service their debt and spend money as well. And that creates a positive multiplier effect in the economy. And I prefer that as a strategy to just handing out cheques on a blanket basis, particularly to those people who are still in work. I'm absolutely in favor of cheques going to help those families who are in financial difficulties and have lost their jobs. But I would much rather see a policy that is directed towards the creation of real jobs, to improve the physical and digital infrastructure of economies that really need that money spent on it, as a way of moving us away from this crisis.

• 25:54 Paul Dixey:

So far, the US has over US$3 trillion of stimulus, this latest package is US$1.9 trillion. And then after that, he's then going back to Congress to try and get some more money for, as you say, this infrastructure spend. And while we're on infrastructure and the like in energy and things, perhaps you could give us a bit of a flavour into what you're doing within your fund, in terms of playing some of the themes that we spoken about today?

• 26:26 Tim Gregory:

We have been playing that infrastructure theme, believing that was the right way for governments to fiscally stimulate the economy. But alongside that, we have been adding to some of the resources positions within our portfolio. We continue to like gold, although that hasn't behaved as one might have hoped and expected in a period of dollar weakness and inflation risk, probably following more the short term rise in interest rates. But I believe that will still have a role to play against inflation. We've been able almost for the last decade, to ignore the bank sector as a very difficult place to invest, but that sector has been improving its performance, reflecting the possibility that we're going to see higher interest rates - so we've been adding a little bit to that area, as well. We can't invest in cryptocurrencies, which could be a way that would be seen as offsetting all this unbelievable money printing that's gone on, we can't do that within our portfolio. So because we run a strategy, which is purely based around investment in equities within our fund, albeit that we can hold cash if we're very cautious, we are quite limited. So our additions to oil, having owned no no oil for a long time, our additions to banks and our additions to resources and infrastructure, that's been the way that we've tried to reflect the possible changes that we're seeing in the shape of the economy going forward. I'll hand over to Simon here, because as the CIO of a wealth management business, they have a slightly different toolbox to approach this. So he would have a probably slightly different take on that.

• 28:06 Simon King:

I think our underlying views are very similar. But obviously, we have the ability to look at things on more of a multi asset basis. So our remit enables us to invest in different areas than Tim can with his equity fund. We're always looking to diversify our portfolios. At any point in time, we like to have balance within them, given our short-term views on inflation, we’re weighting more heavily to things that offered some protection against inflation in the short-term. So they would include the obvious things such as gold, and indeed, commodities generally, holdings in things like iron ore, and indeed some of the softer commodities. Obviously, a traditional way to go would be index-linked instruments predominately gilts and treasuries in the US. But as we pointed out, they've been driven to very high levels in terms of price, low levels in terms of yield, although that has started to reverse. And again, in in past periods of high inflation, the high yield market has offered you some sort of protection, but again, because of the unique nature of QE the high yield market has also performed very strongly in the last couple of years - so it doesn't maybe offer some of the protection it would have done in the past. In terms of equities, we always like companies with very strong pricing power, we think that's a fundamental prerequisite for any holding within our portfolios. And hopefully those companies will fare relatively well during a period of high inflation just because you need the ability to be able to pass on price increases to your customers, so you need a strong franchise. The areas we would be more concerned about would be some of areas in particular Italy, tech because of its long duration and people looking a long way into the future to justify valuations. If we're saying there's more uncertainty on a long-term basis, then obviously, they have to suffer. But even there, it's not all tech, some of the very largest companies, which have driven the market, we believe, continue to offer some very attractive growth prospects in some of the more esoteric and very highly rated companies. We do expect to see continued pressure on those prices.

• 30:32 Paul Dixey:

And just on the tech side, Tim, I wonder whether you could comment on what you're doing in the fund on the technology side of things?

• 30:41 Tim Gregory:

So that's a really interesting point, because, obviously, they are that higher growth part of the market that would be perceived as vulnerable to rising rates. And, because we've been rebalancing the portfolio, we have been using new inflows into the fund to add to some energy, infrastructure, resources, and financials. And obviously, that has been at the expense to a degree of not adding to our exposure in technology. But to be clear on that, most of our technology exposure is in what we call very high quality, great moat businesses with very, very strong franchises, and to Simon's point, have very good pricing power going forward. And a lot of those businesses have been significant beneficiaries of the acceleration in the digitalization of the economy that we've seen. So whilst we acknowledge that the stocks that encompass some of the FAANG companies like Microsoft, Amazon and Google - which actually will be a big beneficiary of normalization of the economy - we don't really see, because of the phenomenal cash flows these businesses generate and the really strong positions that they've got, those as the companies with the material excesses in their valuations. Yes, we absolutely acknowledge that they have performed brilliantly, and they have benefited from this low interest rate cycle, but we don't particularly see those as the big risk in markets, relative to some of the really elevated valuations you see in and around the technology space, in and around renewable energy, and those parts of the market that have been so strong and really benefited from the amount of cash that there has been sloshing around markets over the last few years because of the policies that we've talked about.

• 32:50 Paul Dixey:

There's just one last point that we should probably cover, over the last few days we've seen this sort of rotation out of some of the more highly valued sectors of the market and into the more reflationary trades and the opening up of the economy. I wonder, with rates potentially going up and inflation in the system, whether volatility is something that's also on your minds, and I'm guessing in a highly volatile market, having active managers is probably a good thing.

• 33:23 Simon King

As an active manager, obviously, we would very much concur with that view. But you're absolutely right, volatility is going to pick up and we're in uncharted territory in so many areas: the rise of the retail investor; the rise of the Reddit-style investor, people are prepared to take on perceived short positions there are all sorts of things going on, which is going to increase volatility, and obviously, all the other things we've already spoken about. So yes, I would argue that this is a time to know your companies very well in the equity space, have a very clear understanding of what you're doing and why you're doing it.

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