Looking for the stag in stagflation - Rathbones

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Looking for the stag in stagflation - Rathbones
Issue 31 —
                                                                                          ­ First quarter 2022

Looking for the stag in stagflation
Although consumer prices have been rising rapidly, they’re likely to fall back
this year and the risks of entering a period of stagnant growth remain remote

In brief

Not all geeks are American
The movers and shakers of
the future could be anywhere

Growth vs value?
The quality and visibility of
company profits are what matter

Net zero growth
Will the green transition help or
hinder economic expansion?

Paying down the debt
Beware the growing pile of gilts as
the UK’s credit card bill comes due

                           The final quarter of 2021 proved to be an eventful one for the global economy,
                           with surging inflation and ongoing concerns about supply shortages. Yet markets
                           performed relatively well over the period despite the new Omicron strain adding to
                           the uncertainty. As we look ahead to 2022, economic indicators suggest the post-
                           COVID recovery should continue, and so too should earnings growth.
                               Our lead article looks at the buzzword of the moment — stagflation. As investors’
                           fears of the potential stagnation of output coupled with rising inflation ebbed
                           and flowed, equity and bond markets experienced some volatiliy. What will this
                           uncertainty mean for the year ahead?
                               On page 5, we look at the domination of the markets by US-based tech firms, as we
                           ask if all the geeks are American. Where should we look to for the next wave of tech
                           innovation (and investment opportunity) — and is it necessarily going to come from
                           across the pond?
                               After the initial wave of selling amid the first lockdowns in March 2020, global
                           equity markets have been on a more or less upward path, but leadership has shifted
                           from one style to another. But rather than focus on styles, such as ‘growth’ versus
                           ‘value’, we explain why we think the best approach is to look for companies with
                           quality and durability of earnings growth, whatever style category they might fit into.
                               On page 8, we explore whether the transition toward a world of net-zero carbon
                           emissions will boost overall economic output or hinder it. There is hope that it could
                           have a net positive effect, but governments and business need to start taking action
                           now to avoid a more disruptive transition.
                               Lastly, on page 9, we focus on the UK’s large ‘credit card’ bill, as pandemic related
                           borrowing starts to come due. Having borrowed more in the 2020/21 fiscal year than
                           at any time since records began in 1946, more of this debt will have to be absorbed by
                           the market if the Bank of England starts to wind down its purchases of gilts this year.
                           That’s one of a number of factors that make us cautious about UK gilts.

                           We hope you and your family remain healthy and safe. We also hope the new year
                           will bring more of a return to normal, including the chance to meet and collaborate
                           once again. In the meantime, we will continue monitoring how the investment
                           environment is evolving as the world reopens and we start to see what the ‘new
                           normal’ looks like. Please visit rathbones.com to find out more about our latest views.

                           Liz Savage and Ed Smith
                           Co-chief investment officers

2   rathbones.com          InvestmentInsights | Issue 31 | First quarter 2022
Looking for the stag in stagflation

Inflation is high but the pace of
economic growth isn’t stagnating

Global equity and bond markets had a bumpy end to 2021 as investors began to fear
the worst of both worlds — stagnating output and persistently rising inflation, that
nasty combination called stagflation. While we do think inflation will begin to fall back
from the spring, there is considerable uncertainty around its outlook. However, fears
of stagnating growth look overdone.

We see encouraging signs for equity           Looking for the right signal                                   flattening but still upwardly sloping yield
investors in purchasing managers indices      The yield curve has started to flatten                         curve denotes a sub-par environment
(PMIs) of global business activity and        again (financial market shorthand for                          that should cause investors concern.
other leading economic indicators.            a narrowing difference between the                                  Since the relationship is not a linear
In general, they remain strong and            yields on longer versus shorter-dated                          one, many analysts (including us)
consistent with continued momentum            US Treasury bonds) and some investors                          transform the signal sent by the yield
in company earnings growth. These             are citing this as a reason to be negative.                    curve into a probability of recession
indicators are moderating from their          That’s because it’s seen as signalling                         using what we call a non-linear model.
extreme highs as economies initially          rate rises in the short term and slowing                       Even in September, after a summer of
roared back to life from pandemic-            growth further down the line. However,                         flattening, the yield curve still suggested
related shutdowns. But we are a long          a flattening yield curve is not on its own                     a 0% chance of recession according to
way from stagnating growth, much less a       cause for alarm.                                               this model.
contraction.                                       The relationship between yield
     As the post-COVID recovery enters        curves and the business cycle — or GDP
its next phase of expansion, we think         growth or stock market returns, for that
business investment is likely to be           matter — is not linear. After the yield                        The yield curve has started to
a driving force. Both in the US and           curve flattened over the summer, an                            flatten again (financial market
worldwide there is evidence of a strong       argument was floated along the following                       shorthand for a narrowing
pick-up in business capital spending          lines —the yield curve is flattening, it                       difference between the yields
(capex) plans. As well as preventing          may invert next. While an inverted curve
stagnation, this factor is also likely to     (when longer-dated yields fall below
                                                                                                             on longer versus shorter-dated
ease inflationary pressures.                  short-dated yields) tends to be associated                     US Treasury bonds) and some
     More and better tools lead to            with impending recession (figure 2,                            investors are citing this as a
enhanced productivity growth; better          overleaf), that doesn’t mean that a                            reason to be negative.
productivity puts downward pressure
on unit labour costs; and unit labour
costs tend to correlate with core inflation   Figure 1: Unit labour costs and inflation
(figure 1). Minutes from the latest           Wage inflation tends to correlate with core inflation, represented here by the Fed’s favoured
meeting by the US Federal Reserve (Fed)       Personal Consumption Expenditure (PCE) measure..
have also noted anecdotal evidence of                    Unit labour costs (annual change, %)    Core PCE inflation
the increased use of automation by many        15

businesses in the face of ongoing labour       12
market shortages.                                9
     Equity investors can also appeal to
history for some level of comfort. Profit
margins nearly always expand during
periods of economic growth (with sales           0

going up by more than costs). In addition,      -3
since the turn of the last century, profit      -6
growth has only failed to beat inflation          1960      1965      1970     1975     1980    1985     1990     1995     2000   2005   2010   2015   2020

during the great depression of the 1930s      Source: Refinitiv, Rathbones.
and in 1910.                                  Past performance is not a reliable indicator of future performance.

                                              InvestmentInsights | Issue 31 | First quarter 2022                                            rathbones.com     3
Looking for the stag in stagflation

     In fact, because yield curves start       of rate hikes in the US, UK and Europe.                            companies with persistent momentum
to flatten mid-cycle, a recent study in        Both the Bank of England and the Fed                               in generating good-quality, growing
the Journal of Investment Management           made surprisingly hawkish changes to                               profits makes sense, irrespective of
(JoIM) found that flattening is actually       policy in December and bond and equity                             styles. Strong earnings momentum
associated with a more stable growth           markets were unperturbed.                                          can be found in both value and growth,
environment —   ­ that’s good news for                                                                            cyclicality and defensiveness, and
investors, not bad.                            Keeping an eye on earnings                                         these more ‘top-down’ macro factors
     Another crucial lesson to heed is         Still, our relative optimism shouldn’t                             are likely to be a less relevant source of
that the window between inversion              lead us to be complacent about the                                 differentiation.
and recession tends to be long, 14 to 15       many challenges facing investors in the                                In the US and other major markets,
months on average, and has been getting        year ahead — after the blistering gains in                         average earnings continued their streak
longer with time. This makes it harder         equity markets coming out of the worst                             of comfortably beating expectations
for investors to use the yield curve as        of the pandemic, it’s likely to be a difficult                     in the latest quarterly results, though
a signal, as equity markets only lead          year by comparison. One major challenge                            guidance on future earnings was
recessions by three to six months. Selling     will be to work out where the next leg of                          more cautious than expected. Supply
equities as soon as the curve inverts          growth is going to come from, while also                           chain disruptions and labour supply
could cause you to miss out on rising          navigating the supply chain and labour                             shortages could also continue to
stock prices for rather a long time, let       market disruptions and government debt                             weigh on profit margins and need to
alone selling them when the curve starts       burdens that the pandemic is leaving in                            be watched carefully on a case-by-case
to flatten.                                    its wake.                                                          basis. Still, though caution in the face
                                                    We would be cautious about having                             of uncertainty is warranted, the bar for
Regaining some balance                         any significant bias toward a particular                           earnings expectations in 2022 may now
The big worry for 2022 is the potential        style, especially highly valued ‘growth’                           be set sufficiently low to limit the risk of
trade-off between growth and inflation,        companies or ‘cyclical’ shares that are                            disappointment.
for a corollary of 2021’s growth bonanza       more sensitive to broader economic
has been steeply rising prices, as we’ve       conditions. Both of these could come                               * www.rathbones.com/knowledge-and-insight/
noted in this quarter’s Investment             under pressure if bond yields resume                               2021-and-unusually-uncertain
Update.* US inflation has reached a three-     their rise or the economy stutters. There
decade high — UK inflation is likely to do     has been relatively little differentiation
the same in the spring — and there is an       between these and other investment
unusually wide fan of possible outcomes        styles this year, which is typical in the
from here for investors to be alert to.        middle of the economic cycle when the                              Our relative optimism
     Overall, excess inflation is primarily    initial spurt of growth has peaked.
                                                                                                                  shouldn’t lead us to be
about the unusual composition of                    In the article ‘The quality and
spending. Consumer goods inflation rose        visibility of company profits are what
                                                                                                                  complacent about the many
in line with spending on goods. Demand         matter’ on page 6, we explore more about                           challenges facing investors in
here has fallen sharply, and it is difficult   why we think a ‘bottom-up’ focus on                                the year ahead.
to see how consumer goods inflation
could stay elevated for too long without
the demand.                                    Figure 2: The yield curve and recessions
     High inflation in consumer goods          While an inverted curve tends to be associated with impending recession, that doesn’t mean a
is unlikely to fully pass over to high         flattening but still upwardly sloping yield curve is a reason for investors to be concerned.
inflation in services as spending
normalises. Our base case is for global                 1–year to 10–year yield curve        US recession
inflation to fade meaningfully from the
spring, but to remain elevated until at
least 2023. Much depends, however, on a
resumption of normal spending patterns,
which could be stalled by Omicron.               0

     Central bankers have been clear that       –1

there is little they can do to stem the         –2

unique causes of today’s inflation, but         –3

that they are more mindful to tighten           –4
                                                 1962       1967      1972      1977      1982      1987      1992      1997      2002      2007      2012      2017
policy as output and employment are
strong. Rising rates would ordinarily be a
                                               Note: The difference between 10-year and one-year US Treasury yields is used here to represent the yield curve
headwind to valuations, but markets are        Source: Refinitiv, Rathbones.
already pricing for a substantial number       Past performance is not a reliable indicator of future performance.

4   rathbones.com                              InvestmentInsights | Issue 31 | First quarter 2022
Not all the geeks are American

The movers and shakers of
the future could be anywhere

We often get asked if US equities are in     and stock market leadership. For long-                            More winners to choose from
a bubble. Bubbles are characterised by       term investors like Rathbones, it makes                           A repeated question in recent years
the separation of asset prices from their    sense to focus on those companies                                 — which has been amplified by the
fundamental value. The outperformance        that can benefit from their durable                               pandemic — is whether investors are at
of US equities — and particularly            competitive advantages.                                           greater risk of relative loss if they don’t
America’s technology giants — has been            Research by investment bank                                  pick the winners. This has tended to be
driven as much by their earnings growth      Goldman Sachs suggests opportunities                              shorthand for that elite club of US tech
as by their valuation. Unlike the tech       for investing in these future “innovators,                        giants. What the question boils down
stocks at the turn of the millennium,        disruptors, enablers and adapters” can                            to for investors is whether the largest
these companies generate billions of         be found across virtually all sectors,                            earners are increasing their share of total
dollars of earnings growth, even though      including retail, healthcare and other                            earnings — or what we might call winner
they also spend billions on research and     more traditional industries.                                      takes all. Research we conducted in
development and other intangible items,           With the world’s focus turning to                            2019 showed that, while the share of the
which accounting rules don’t allow them      a green transition, this could have the                           largest earners was indeed large, it hadn’t
to ‘capitalise’ (effectively spread out      effect of amplifying innovation and                               changed much over the past 30 years. If
over a number of years) and instead get      disruption in industries like energy,                             anything, that share had been decreasing
subtracted from earnings immediately.        utilities, industrials and transportation.                        in more recent years.
Our research suggests that adjusting         Companies already using technological                                 While we’re not claiming to have
earnings and book value for what we call     innovation to help drive the green                                found the winners of the next 10, 20
“knowledge capital” and “organizational      transition can be found across a wide                             years or more, we believe there is good
capital” makes their valuation multiples     spectrum of industries and geographies,                           reason to think there will be plenty of
look far less lofty.                         from small hidden gems to large                                   opportunities across many and varied
     Much of the difference in the           established brands.                                               sectors, and in lots of different places.
valuation of these American companies             Goldman’s research suggests the                              That’s good news for active global
and more averagely valued ones in the        split is fairly even across North America,                        investors like ourselves — as well as for
global index can also be explained by        Europe and Asia. That compares with                               our clients.
interest rates. American tech companies’     a much greater US concentration of
earnings are expected to grow at a higher    about 60% in the current makeup of
rate for longer than the average business.   the MSCI World Index, for example
That means more of today’s price is          (figure 3). Another case for having an
determined by future earnings, and so        active investment approach, rather than
it’s more sensitive to the discount rate     passively tracking an index.
used to translate tomorrow’s earnings
into today’s money. As interest rates have
fallen, American tech valuations have        Figure 3: Geographical breakdown of headquarters location
risen. None of these things suggest a        Research suggests tomorrow’s winners can be found across virtually all sectors, including retail,
separation of prices from reality.           healthcare and other more traditional industries.
     That said, as new technologies come
                                                     Innovators + disruptors + enablers + adaptors                   MSCI All Country World (market cap weighted)
to the fore we must ask, are all the geeks
American, and do they all work for the
US tech giants? Of course, the US tech                            Africa
                                                                Middle East
                                                                            Latin America
                                                                                                                            Middle East
                                                                                                                                        Latin America
sector is and will remain a big driver of                          1%                                                          1%
                                                                                                                 Asia Pacific
innovation and overall earnings growth,                                                                           ex Japan
                                                 Asia Pacific                                                       12%
but future investment opportunities               ex Japan                  Japan              North America                           Japan
                                                    25%                      4%
could be spread more widely.                                                                       35%                                  7%
                                                                                                                                                            North America
                                                                                                                  Europe                                        63%
A competitive advantage
As we explore in our lead article,                                                           33%
investors have been wrestling with the
implications of post-pandemic reopening      Source: Goldman Sachs.
in terms of inflation, monetary policy       Past performance is not a reliable indicator of future performance.

                                             InvestmentInsights | Issue 31 | First quarter 2022                                                         rathbones.com       5
Growth vs value?

The quality and visibility of
company profits are what matter

Global equity markets have been on an        far more resilient as they benefited from             forecasts have been the key determinant
upward path more or less since their         a surge in investment in the computers                of stock performance. This is not
precipitous drop in March 2020, when         and remote hosting of cloud software                  surprising, as it is what tends to happen
the world first went into lockdown.          applications that facilitated remote                  in the middle of an economic cycle, after
Over the course of this nearly two-year      working.                                              the initial spurt of growth at the start of
advance, leadership has passed from              Following the November 2020                       the recovery.
one investment style to another. But         announcement of effective vaccines,                       The rebound in economic activity
rather than choosing broad styles like       market leadership shifted to the sectors              has been so robust that it has created
growth or value, we believe a more           and stocks that had underperformed                    bottlenecks in the supply of various
company-specific focus on the quality        through the initial pandemic crisis and               economic inputs, from labour to
and durability of profits will continue to   would benefit from a normalisation of                 commodities and freight services, which
be the best guide for finding long-term      economic activity (figure 4). Companies               since the second quarter of the year have
returns as the world moves on towards a      that become known as ‘recovery’ stocks                caused heightened inflation concerns for
post-COVID normality.                        were found in both traditional value                  business owners and policy makers alike.
    The market’s recovery was initially      areas (which typically trade at lower                 This has created a volatile and uncertain
driven by the swift reaction of Western      valuations), such as energy and banks                 environment for profit margins and
governments to lockdowns, limiting the       and so called ‘cyclical’ companies that               corporate earnings, which has only been
potential for them to cause permanent        are more geared to economic recovery,                 exacerbated by the emergence of the
structural increases in unemployment         such as travel and leisure, which had                 Omicron variant.
and losses to economic productivity.         suffered from COVID-related closures                      Further uncertainty surrounds the
    The investment styles of ‘defensive      and weakened demand.                                  pace and timing of monetary tightening
growth’ and ‘quality’ initially led the                                                            as authorities respond to inflationary
recovery in 2020 as investors shifted        Persistent performance                                pressures proving less transitory than
towards beneficiaries of COVID-driven        The outperformance of these recovery                  had been initially expected. Rising short-
changes. They include consumer               stocks persisted until February 2021 and              term bond yields (figure 5) are typically
staples that were favourably exposed to      the emergence of the Delta variant, when              not conducive to segments of the
increased consumption as people spent        concerns about the pace of recovery                   market with higher or more defensive
more time at home (such as packaged          temporarily reasserted themselves. Since              growth rates. As more of their price
food and dishwasher tablets) and             March 2021, there has been relatively                 today is determined by future earnings
technology companies which facilitated       little differentiation between value and              (compared with the average company),
and benefited from an acceleration in        growth investment styles, or between                  they are more sensitive to these short-
e-commerce and in remote working             cyclicality and defensiveness. Earnings               term yields, which provide the discount
and networking (defensive growth).           momentum and revisions to earnings                    rate that is used to translate tomorrow’s
Companies with recurring and
predictable revenue streams (quality),
affording them earnings resilience,          Figure 4: Global performance of cyclical relative to defensive sectors
were favoured over so-called cyclical        Cyclical sectors have given back some of their earlier outperformance as style leadership has
companies whose demand was more              shifted over the course of 2021.
sensitive to economic conditions.
    The unique conditions of the             112
COVID downturn, in which lockdowns
restricted mobility and caused entire
purchasing channels such as restaurants
and high street stores to be shut down
for extended periods of time, led to
weakness in businesses reliant on             98
footfall, which would have held up much       96
better in more conventional downturns.        94
                                                   Rebased to 100 from January 2021

Conversely, some sectors that tend to be           Jan        Feb       Mar   Apr     May    Jun    Jul     Aug   Sep    Oct     Nov    Dec

cyclical in more ‘normal’ circumstances,     Source: Refinitiv, Rathbones.
such as semiconductors, proved to be         Past performance is not a reliable indicator of future performance.

6   rathbones.com                            InvestmentInsights | Issue 31 | First quarter 2022
Growth vs value?

earnings into today’s money. Yet some of     online gaming, online food delivery and                        likely continue to be driven less by any
the leaders in these sectors have thrived    other aspects of online consumption),                          particular investment style than by
and indeed re-rated in what is turning       growing automation and digitalisation of                       picking the stocks with the best earnings
out to be a productive environment for       industry and increasing electrification of                     momentum — underpinned by structural
stock selection.                             energy systems and transport.                                  growth drivers and a strong business
    One example is software giant                Electrification is part of a wider                         model that is resilient to inflation. As the
Microsoft, which reported 22% sales          structural trend of investment in                              initial recovery comes off the boil and
growth in the third quarter of 2021          sustainability and transition towards a                        enters its next phase of normalisation,
driven in particular by Azure and cloud      more renewable-energy-based system.                            a balanced approach seems warranted,
services as well as the ongoing rollout      The ever-increasing importance of                              including exposure to companies in
of subscription services such as Office      this transition to ‘net zero’ carbon                           both the growth and value camps (you
365 and Dynamics 365. Another is spirits     emissions was evidenced by government                          can read more about our views on the
company Diageo, which was initially          and corporate commitments                                      economic outlook in our lead article on
hit by the COVID-driven closure of bars,     around November’s COP26 climate                                page 3). Whatever the style, emphasising
but swiftly used its market leading data     change conference in Glasgow.                                  these company-specific qualities
analytics and agile business model to        (You can read about the investment                             seems to us to be the best method for
pivot its marketing and distribution         implications of COP26 in our post-COP                          generating future returns.
towards at-home drinking occasions.          InvestmentUpdate* and about the global
Of course, this past outperformance          economic impact in our article ‘Will the                       * www.rathbones.com/knowledge-and-insight/
may not be repeated as the recovery          green transition help or hinder economic
moves into its next phase and beyond,        expansion?’ on page 8.)
but it highlights the need to look to            A key factor for success in 2021,
company specifics rather simply focus        given the sharp rise of inflationary
on particular styles.                        pressures, has been inflation sensitivity
                                             (how flexible companies can be in                              The low-hanging fruit of
Recovery from the lows                       finding lower cost inputs, and/or how                          recovery has been reaped
Many ‘COVID victims’ have enjoyed            well they can pass on higher costs to                          and performance will likely
a recovery from depressed levels             customers), which is generally a function                      continue to be driven less by
of profitability and share price, but        of strong competitive advantage and
                                                                                                            any particular investment
others such as travel-related stocks         differentiation, high switching costs and
have continued to languish as full           relatively sticky customer demand.                             style than by picking the
reopening and normalisation have been            The low-hanging fruit of recovery                          stocks with the best earnings
delayed. The value sector of mining has      has been reaped and performance will                           momentum.
also seen more muted performance
because of its reliance on demand for
iron ore from Chinese construction           Figure 5: Short-term US Treasury yields are on the rise
and infrastructure development. After        Rising short-term bond yields are not typically conducive to segments of the stock market with
surging in 2020, the curtailment of these    higher or more defensive growth rates.
activities and the travails of the Chinese                US 1-year Treasury yield (%)
property development sector have led          0.35
to a collapse in iron ore prices in recent    0.30
    Many of the stocks that enjoyed
outperformance in 2021 benefit from           0.20

structural tailwinds which have persisted     0.15

throughout the last two years almost          0.10
irrespective of COVID (and often              0.05
accelerated by it). These include the
increased penetration of cloud-based             Jan 21     Feb 21    Mar 21     Apr 21   May 21   Jun 21   Jul 21   Aug 21   Sep 21   Oct 21   Nov 21   Dec 21
software and services, the inexorable rise   Source: Refinitiv, Rathbones.
of e-commerce (along with digital media,     Past performance is not a reliable indicator of future performance.

                                             InvestmentInsights | Issue 31 | First quarter 2022                                                 rathbones.com     7
Net zero growth

Will the green transition help or
hinder economic expansion?

A key question for investors over the         might find that the transition actually                          the benefits over time. Economies and
first half of this century, and one for       boosts growth. Including the first                               businesses can evolve and adapt to well
which there is a lot of diverging opinion     industrial revolution we have had five                           signalled and spread-out changes, but a
out there, is whether the move toward         great waves of productivity growth:                              more sudden imposition of policy — for
‘net zero’ carbon emissions will help         energy revolutions have been involved                            example in 2028 or 2029 — could entail
or hurt economic growth. Though the           in four of them. So why can’t we have                            huge transition risks. And it isn’t just
recent COP26 global climate summit in         another industrial revolution powered by                         about policymakers. We urge higher
Glasgow had its disappointments, we           cheaper green energy?                                            carbon businesses we speak with to
remain hopeful that governments and               That’s the optimistic view.                                  adopt robust decarbonisation policies
businesses will avoid a negative impact       Economists at the Bank of England                                today, to decrease that risk of a more
from this transition by taking sufficient     (BoE) and the Network for Greening the                           sudden, financially disruptive policy
action sooner rather than later.              Financial System (NGFS) suggest the                              being imposed by governments further
     A recent report from the International   transition to net zero is likely to reduce                       down the line. Those same economists at
Energy Agency (IEA) concluded that            GDP by 2050, but only by 1 percentage                            the BoE/NGFS expect GDP in 2050 to be
annual investment in the energy               point. So only a little less growth than                         5 percentage points lower if we delay the
industry will need to rise from $2 trillion   if we do nothing. A recent review of                             transition by 10 years.
today to $5 trillion by 2030 if we are to     the academic literature showed an                                    You can hear more on the net-zero
transition to a net zero world. But you       inconclusive split between studies that                          transition from our co-chief investment
can’t simply add that extra                   suggest it would help, hinder or make no                         officer Ed Smith, stewardship director
$3 trillion per year to annual GDP and        difference to economic growth.                                   Matt Crossman and Kate Elliot, head of
say ‘happy days, more growth’.                                                                                 ethical, sustainable and impact research
     That would be to ignore the question     Worth the cost                                                   at Rathbone Greenbank Investments
of where that $5 trillion dollars is coming   Our base case is a small negative impact                         in this video* of our November COP26
from. Capital doesn’t grow on trees.          on growth by 2050, but we are optimists.                         webinar. We’ll also be communicating
It’s most likely to come from capital         Eliminating the huge negatives from not                          in greater depth on this crucial question
that otherwise would’ve been invested         combating climate change, which don’t                            of economic impact over the coming
elsewhere. In which case, will this net-      show up in GDP figures but do actually                           months — so stay tuned by visiting
zero transition lead to less innovation,      impact our wellbeing, is probably worth                          rathbones.com or speaking to your
less productivity growth than if this         that cost (figure 6).                                            investment manager.
capital wasn’t diverted from elsewhere?           Policymakers need to take action
That’s a really crucial question.             now, however. That’s the best way to                             * www.rathbones.com/knowledge-and-insight/
                                              prevent the economic costs outweighing
An optimistic outlook
We are optimistic for a couple of reasons.
First, some of this investment is likely      Figure 6: Expected average UK annual GDP growth (%)
to be in public infrastructure, which         Early and orderly action to combat climate change would be expected to produce better future
encourages lots of job creation and           growth than doing nothing or starting too late.
investment and raises productivity. The
                                                      Year 6–10      Year 11–15         Year 26–30
second reason is that the fall in the cost
of clean energy technology has exceeded
even the most optimistic expectations
from 10 to 20 years ago. There is some
interesting evidence that the change          1.0
in the cost of climate-change fighting        0.8
technology assumed by many of the             0.6
models used to determine the economic         0.4
impact is too slow.                           0.2
    If you assume the cost of these           0.0
                                                             No additional action                      Early and orderly               Late and disorderly
technologies falls at a pace similar
to what we have seen in many other            Source: Network for Greening the Financial System, Rathbones.
technologies in the last 50 years, you        Past performance is not a reliable indicator of future performance.

8   rathbones.com                             InvestmentInsights | Issue 31 | First quarter 2022
Paying down the debt

Beware the growing pile of gilts as
the UK’s credit card bill comes due

To pay for its economic response to                 Looking ahead to the 2022/23 fiscal                  The fall in gilt yields (meaning
the coronavirus pandemic, the UK                year, Barclays estimates just under                  prices increased) that followed the
government borrowed more in the fiscal          £73 billion of net gilt issuance. But this           autumn Budget, when estimates for gilt
year 2020/21 than at any time since             doesn’t take into consideration the                  supply for this fiscal year were lowered
records began in 1946. It’s not as though       potential for the BoE to stop reinvesting            significantly, shows that net supply
this episode has escaped the notice of          the proceeds from its gilt holdings as               can affect gilt prices. The potential for
bond investors — plenty has been written        they mature, which its Monetary Policy               that supply to increase significantly
about the increase in government                Committee (MPC) has indicated will                   going into the next fiscal year is one of
borrowing during the health crisis. So          happen when it has increased its base                a number of factors that make us wary
you would be forgiven for wondering             rate (its official lending rate) from 0.25%          of having too much exposure to longer-
why UK government bonds (gilts)                 to 0.5%. Market-based rate expectations              dated gilts, given their greater sensitivity
haven’t taken a hit.                            at the time of writing suggest this will             than shorter-dated gilts to any rise in
    A host of factors can influence the         happen in May. That would result                     yields from their current low levels.
price of government bonds. However, all         in another effective £9 billion of net                   As we approach 2023, we expect
else being equal, a large increase in the       supply (from redemptions that are not                a growing focus on the BoE’s plans to
supply of something would be expected           reinvested). That would take us to net               stop reinvesting the proceeds from gilt
to put downward pressure on its price           supply (ex-QE) of around £82 billion, the            redemptions as some larger holdings
(the same number of pounds spread out           highest level for a number of years.                 within its QE programme reach maturity.
over an increased amount of gilts).
    When analysing government                   Rate expectations
bonds, we look at net supply. This              One of the reasons we disagreed with
figure is supply less redemptions on the        market expectations for the base rate to
assumption that bondholders would               reach 0.5% in February is because
reinvest the capital received from              £25 billion of BoE gilt holdings are
those redemptions, thus absorbing               maturing in March. According to the
an equivalent amount of new supply.             MPC’s guidance, this would therefore be              One of the reasons we
However, we also need to consider the           added to the net supply of gilts rather              disagreed with market
impact of quantitative easing (QE), or          than be reinvested. Still, net supply for            expectations for the base rate
gilts purchased by the BoE, which don’t         the first three months of 2022, in other
                                                                                                     to reach 0.5% in February is
have to be absorbed by the market               words the last quarter of fiscal year 21/22,
(figure 7).                                     will be negative and that means there                because £25 billion of Bank
                                                won’t be any supply pressure on gilts in             of England gilt holdings are
Under pressure                                  the near term.                                       maturing in March.
Once we look at net supply excluding
QE (net supply less QE purchases
undertaken in the year, a more ‘true’           Figure 7: Bank of England gilt purchases (£ billions)
reflection of net supply in our view), the      The central bank’s substantial quantitative easing programme has distorted the price of
lack of pressure on gilt prices from the        government bonds and is likely to continue to exert its influence.
pickup in supply makes more sense. In
total the BoE announced £450 billion of
additional QE in 2020 (£440 billion of
which related to gilts, the final £10 billion
relating to corporate bonds).
    Not all of this was undertaken in
fiscal year 20/21, the final purchases were
being made in December. Excluding QE,            400

the net new supply of gilts looks far less
alarming. Net issuance of £388 billion           200
                                                       2012      2013   2014      2015      2016     2017    2018     2019    2020     2021
becomes just under £66 billion, while for
fiscal year 21/22 the net supply excluding      Source: Bloomberg.
QE is expected to be just over £21 billion.     Past performance is not a reliable indicator of future performance.

                                                InvestmentInsights | Issue 31 | First quarter 2022                               rathbones.com   9
Financial markets

High inflation and uncertainty about
                                              GDP growth                                                           Inflation
central bank policies raised concerns
                                                                                             % annual change                                                        % annual change
about the economic recovery. Rising             4                                                                   7
COVID infections and the new Omicron            2                                                                   6

variant were another cause for concern,                                                                             5
and social restrictions came back in                       eurozone
December. However, leading economic                                                                                 3
indicators pointed to a continuation of        –4
strong growth as the world economy             –6
enters the next phase of recovery from                                                                                                   Japan
                                               –8                                                                   0
the pandemic.
                                              –10                                                                  –1
     Despite ongoing concerns, global                                                                        UK
equities performed well at the start of       –12                                                                  –2
                                                                                                                          2017       2018        2019      2020         2021
the period and finished the year with           2011        2013      2015          2017     2019       2021

decent gains. In October, US stocks had a     Source: Factset and Rathbones.                                       Source: Factset and Rathbones.
record month, with the S&P 500 surging
by 6.9%, its biggest monthly gain for
2021. The FTSE 100 also rose to a near        Sterling                                                             Equities
20-month high in October, recovering           $
                                                                                                             1.5   220
all losses since the pandemic began.                                                                                      MSCI World Total Return Index (in sterling)
                                                                                                                          FTSE All Share Total Return
However, at the end of November the                                                                                200
                                              1.5                                                            1.4
discovery of the new Omicron variant
                                                                                                US dollars         180
and what it could mean for the potential
                                              1.4                                                            1.3
return of lockdowns unsettled markets.                                                                             160

                                              1.3                                                            1.2   140
Central banks change course
US Federal Reserve (Fed) Chairman                                                                    euros         120
                                              1.2                                                            1.1
Jerome Powell also spooked markets                                                                                 100
when he said it was time to drop
                                                                                                                          October 2016 = 100
the word “transitory” from the Fed’s          1.1                                                            1.0    80
                                                    2017      2018     2019         2020     2021                         2017      2018         2019     2020          2021
statements on inflation, though markets
regained their poise into the end of          Source: Factset and Rathbones.                                       Source: Factset and Rathbones.

December. While the tone from the Fed
has changed, Powell still expects inflation   Government bonds                                                     Gold
to fall closer to the central bank’s 2%
                                                                                           10–year yields (%)                                              US dollars per troy ounce
target over the course of 2022.                4                                                                   2200
    Government debt rallied over the
prospect of widespread COVID-19                3

lockdowns as investors turned to assets
traditionally seen as carrying lower           2
risk. Gold prices also rose as investors                                       US
looked for a safe haven amid increasing
uncertainty and high inflation.                                              UK                                    1400
    It was another rollercoaster quarter
for energy markets, with the price                                                                                 1200
of Brent crude hitting $84 a barrel
                                              –1                                                                   1000
in October before falling back down.
                                                    2017       2018     2019          2020      2021                      2017       2018        2019      2020         2021
European natural gas prices also soared
                                              Source: Factset and Rathbones.                                       Source: Factset and Rathbones.
to fresh records due to worsening supply
from Russia, depleted reserves and high       Past performance is not a reliable indicator of future performance.
demand from Asia.

10   rathbones.com                            InvestmentInsights | Issue 31 | First quarter 2022
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                             Investments can go down as well as up and you could get back less than you invested.
                                     Past performance is not a reliable indicator of future performance.

                                                      InvestmentInsights | Issue 31 | First quarter 2022                                          rathbones.com     11
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