The Balanced Perspective

Iain Power of Truffle Asset Management, in a Q&A with David Levinson, discusses whether we will see real inflation hit our wallets and the implications for the financial markets.

The key drivers for inflation
We're going to see a strong cyclical pickup in short-term inflation. The 3-year US break-even is expecting a 2.7% inflation number and on the 5-year around 2.6%. In the shorter term, there is a strong expectation of higher inflation. There is very strong deglobalization where economies are looking to become self-sufficient in terms of manufacturing. China and the US are good examples of where, on the back of strong nationalist and populist policies, we’re seeing a lot of manufacturing assets being brought home, which comes at the expense of cost. It effectively lifts production costs, which pushes up prices. On top of that there is extreme fiscal stimulus from governments who are running big deficits and monetizing them. If you continue to print money and put it into the hands of the public, they tend to spend it and this can be inflationary.

The bigger, long-term factor and driver is the potential for real wages to start increasing. We’re seeing significant demand coming back online in the global economy as we normalise post Covid. The amount of skilled labour available for these jobs is scarce and we’re starting to see price increases in terms of labour. Once you start getting real wage increases of 3%-4% over time, that could potentially reset inflation expectations a bit higher and we may start to see inflation pick up.

The last factor would be the Fed believing the inflation kick in the short term is transitory and they would rather let the economy run hotter before they react in terms of monetary policy. If it does start to ratchet higher, the Fed may be behind the curve, which is what people are referring to in terms of inflation going higher. Inflation may lift higher to 2.5%-3%. Some of the risks look as though they are skewed towards the upside, although you can make a strong case that some of the strong deflationary forces are still at work.

Global economic outlook
Valuations during Covid became very attractive and the medicine that central banks dealt out to Covid was powerful in terms of very loose monetary policy and fiscal stimulus. This has created an opportunity for an enormous recovery in corporate earnings. We’re seeing global equity earnings growing well in excess of expectations. This is propelling and keeping valuations higher and giving investors the benefit of beta. Equities are maintaining their performance because of the strong earnings recovery even in the face of some valuations, which look fairly stretched in the US.

From our perspective, we’ve been running reasonable risk asset allocations from an SA perspective. From a global perspective, we’ve been pretty positive on some of the ex-US names in the cyclical value camps. It’s likely that those shares and sectors will continue to get the benefit of the strong earnings recovery and the fact that they’re trading on lower multiples relative to some of the more expensive names.

Investors are spoilt for choice. There is lots of earnings growth to be had and you don’t have to pay up for the classic high-quality names that we’ve had in our portfolios to get the earnings growth. It’s a typical cycle with strong earnings recovery and characteristically, in your first year, it will support valuations. The challenge for investors and from an asset allocation perspective will be in the back end of this year into the first half of 2022 where we anticipate a sharp earnings deceleration with valuations becoming more important.

SA economic outlook
From a South African point of view, certain players are benefitting from what happened during Covid and delivered better than anticipated earnings growth. Some of those businesses have taken market share from their peers. Pepkor & Mr Price continue to take share from Foschini, Truworths and Woolworths.

Broadly, the SA domestic universe has fared better. The banks, from a credit and impairment point of view, have delivered better results. The industrials and some consumer businesses have also put in some good performances. Investors recognized that some of those businesses were trading on cheap or lowish multiples and with the benefit of strong earnings growth, these lower multiples have seen decent share price outperformance.

South Africa is standing out as a cheap value market in the context of a global equity universe where valuations have been quite full. Globally, we’ve seen emerging market managers regard South Africa as a recovery value trade, particularly now that our own Covid vaccination process has started, which bodes well for 2022.