01 Jan 2022
We speak to Neil Parker, FX Market Strategist at NatWest Markets, and Seán O’Callaghan, Head of Institutional Banking, Jersey, at RBS International, about rising inflation and its impacts on markets.
What are the expectations for inflation over the next year and their impact on currencies?
Neil Parker: “Inflation expectations have been revised significantly upwards over 2022. Some forecasters think that inflation will drop back in 2023. They assume we’re not going to see the same scale of price increases in commodity, energy or freight over 2023 as we’re currently seeing. I’m not convinced this sufficiently recognises the risk of baking in a lot of the inflation into second-round effects like labour shortage and subsequent wage inflation.
“The developed world has a significant risk of prolonged inflation, prompting higher interest rates that will not benefit economies reliant on low inflation and low interest rates to fuel growth.
“The inflationary pressures currently come from overseas; they’re not domestically generated. But a second-round effect of domestically generated inflation pressures prompted by labour market shortages will have a materially larger relative impact on the economies that haven’t recovered to pre-pandemic levels versus those already well ahead of those pre-pandemic output levels. That puts the US dollar at a competitive advantage over the UK pound and the euro.”
What is driving the increase in inflation?
Neil Parker: “Generally, it is due to an imbalance between supply and demand. There has been a shift in policy, both fiscal and monetary, to support demand, but supply hasn’t caught up. Most of the policies have been focused on increasing demand without thinking what that would mean to the fractured supply chain.
“More specifically, the cost of moving freight, for example, is still much higher than what businesses are used to. Freight movement is one-dimensional, mostly from Asia to the developed world, and little is shipped back; consequently, there is a container shortage. Containers are returned empty, doubling the cost. And lorry driver shortages in the UK, Europe and the US prompted wage increases to attract people into the industry.
“Then on the geopolitical side, you have examples where Russia has restricted the supply of gas into Europe, and consequently gas prices have surged. Equally, many European countries have not been able to fill their gas storage, so they are paying a lot more for gas at a higher spot price.”
Central banks are mandated to keep inflation around 2%. Will they relax this as the world recovers economically?
Neil Parker: “Central banks are looking at this in the round at what is causing inflation and whether it will be long and sustained.
“In the financial crisis of 2008, inflation was considerably higher than target because oil prices hit $147 a barrel. Central banks didn’t raise interest rates because they could see the damage inflicted on GDP.
“It is debatable whether tightening monetary policy will have any materially beneficial effects in bringing down inflation rates now. We know that it could have a material impact in reducing underlying demand in those domestic economies. But the argument would be: is that what you want to do?
“There’s relatively little that central banks can do to put a lid on inflation in the short term. They will be more concerned about influencing the medium to long term by raising interest rates and then affecting individuals to adjust their borrowing and spending behaviour so that inflation will come back down over that period.”
How long can we expect high inflation to be with us?
Neil Parker: “The honest answer is we don’t know. We don’t know how much inflation will impact the high street or the split between necessity goods and discretionary purchases. We also don’t know how long the labour market shortages will remain. Central banks will have to persistently revisit their assumptions about how long high inflation will last.
“I’m not sure central banks should be that alarmed by the short-term inflation spike. They need to be concerned if this spike in inflation leads to a considerable and sustained rise in wages and a considerable and sustained increase in inflation on the high street. But I don’t see it sustained over the medium term. It would mean a further surge in commodity and producer prices, which would further undermine household incomes and spending. So there is reason to anticipate that a slowdown in growth would occur inevitably anyway.”
What do different fund managers need to think about regarding inflation?
Seán O’Callaghan: “Many fund managers will have considered inflation the number one challenge going into 2022, and from speaking to the managers we support at RBS International, there are three key areas they are thinking about.
“Within private equity (PE), the first is borrowing costs and thinking about how high borrowing costs need to go before they start biting into managers’ use of leverage. From what we see, interest rates between 2% to 3% should be manageable, especially for funds with assets which have a strong product range/brand and that can pass on costs to the underlying user.
“The second area is how they identify and manage their assets. When managers are examining the portfolio companies they’re looking to acquire, assessing their growth potential and different exposures to a higher inflation environment, they’ll be thinking about the valuations of potential firms and firms already within their portfolio, and what EBITDA multiples look like versus what inflation will be.
“Then there are the operations around those underlying portfolio companies. As staff and material costs rise, do the managers have the skill sets in those firms to navigate inflationary pressures?
“Finally, fund managers need to think how they attract investors to new funds which they are raising. A key part of this is what hurdle rate they agree with their investors. That rate was driven down over the years because inflation slowed, but if inflation and interest rates swing back up, investors’ real rate of return will be compressed. Investors could tell managers you need to start re-forecasting what needs to be in future fundraising. That is important to think about as managers market to investors.”
What do inflationary pressures mean for different types of funds?
Seán O’Callaghan: “Thinking about PE investment in general and in fact all asset classes, it’s a buy-and-hold strategy. Generally, they will look to buy an asset and hold it for five to eight years.
“If you think about inflationary pressures, they often have short- to near medium-term impacts, but over a medium- to long-term horizon, it will not have the same effect as if you were purchasing in, say, the public equity market, where the term of investment is considerably shorter and more volatile.
“If you look at real estate, for example, and a manager with a strong track record, it can be seen as a safe haven from inflation because it drives up base rates, which drive up valuations and rents, plus usually it has little correlation with stocks and bonds. Again, it is a much longer-term investment class.”
Does inflationary pressure mean that investors might use up dry powder?
Seán O’Callaghan: “There was a massive increase in the money supply due to stimulus packages in recent years. You see different managers having different approaches to using their dry powder. But if you look back at all the analyses, returns have outstripped inflation. This comes back to longer-term holds, where they’ve got a good customer base, a good product, and can pass on costs. It comes down to the manager’s skill and how they tend their portfolio, the asset selection and valuations within the portfolio.”
Are there opportunities through this period?
Seán O’Callaghan: “Good managers adapt their strategies to find those opportunities. The PE industry – and I’m covering all different asset classes here – has been very good at how it evolves to each crisis or situation. Thinking back to the 2008 financial crisis, the private debt sector had very few fund managers within this asset class at that point. Banks started to retrench but managers saw an opportunity, and the scale of how private debt grew over the past 10 to 12 years is phenomenal, with Preqin reporting that the private debt asset class is to grow by 11% annually to $1.46trn by the end of 2025.
“But the losers will be those managers who aren’t prepared, who don’t have the discipline or the relevant stress tests in their modelling to cater for points one and two of my earlier answer (ie borrowing costs, portfolio management, etc). For example, they might not have the correct interest rate hedges built within their real estate portfolios. Or they haven’t accurately predicted how inflation would impact performance and rate of return within their portfolio companies.
“And it could be that the management within those underlying companies doesn’t have the relevant experience or knowledge to navigate the companies through this period of inflation. But overall, the private equity market is well versed with managing through choppy market conditions.”
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