Investors should prepare their portfolios for the return of inflation, according to Miton Group’s David Jane, who said a shift in priorities for central banks and the fading impact of globalisation will upend the market drivers that have prevailed since the financial crisis – and longer, in some cases.
Data from the Office for National Statistics shows the consumer prices index grew by an annual average figure of 1.9 per cent in the 20 years to the start of 2018, compared with 6.1 per cent in the 20 years to the start of 1998.
CPI annual rate since 1998
Source: Office for National Statistics
While Jane, manager of the MI Miton Cautious Monthly Income fund, is not predicting a return to the latter figure any time soon, he said investors need to be aware of the implications on markets now that the disinflationary forces of the past few decades are fading or even reversing.
“It’s worth reminding ourselves of the reasons given for the long deflationary period,” he said.
“First was central bank independence, concentrating on reducing inflation, which is arguably no longer the case.
“Another is globalisation, particularly the rise of China which, given recent talk of trade wars and the growth of wages, seems also to be fading.
“A further one is the global savings glut, as the baby boom generation and the emerging Chinese market drove yields down. This appears to be passing as both cohorts age and move towards spending those savings.”
As a result of these trends, Jane believes it is more likely than not that inflation and bond yields will drift higher over the coming years, subject to the near-term effects of economic cycles.
In such an environment, he said some of the basic presumptions that investors have come to rely on over the past decade or so will be challenged – with traits that have become highly valued falling out of favour, while assets that were previously ignored becoming popular once again.
For example, he said the preference investors have developed for fixed income is likely to fade.
“Rising bond yields mean that capital losses will become the norm, whereas investors have become accustomed to earning both an income and a capital gain on their fixed income portfolios,” the Miton manager explained.
“Many years ago, gilts were known as certificates of capital confiscation during the period of high inflation. In that era, capital was eroded by rising yields and further eroded in real terms by inflation.
“Rising bond yields make decisions around credit selection and duration much harder, as any bond’s yield must be sufficient to offset the potential capital loss from rising rates.” 
Turning to equities, Jane (pictured) said the period of falling inflation and rates has led investors to prefer asset-light, goodwill-driven businesses, particularly those capable of supporting debt, such as mature pharmaceutical businesses and fast-moving consumer goods businesses.
“These companies built their assets (brands or new drugs) with revenue investment while adding further value through taking on debt at falling costs,” he explained.
“In a rising inflation environment, the cost of maintaining those assets will be rising, while the debt will provide a further headwind to growth.”
In contrast, businesses with high levels of fixed assets have been out of favour for many years. Jane pointed out the replacement cost of those assets will rise in the above scenario and with a shortage of savings, capital to build new steel mills, pipelines or railroads, for example, will be scarce.
“We believe the value of existing capital invested will be appreciating as replacement costs rise, and the global savings glut reverses,” the MI Miton Cautious Monthly Income manager said.
“However, in many cases, this type of business often has substantial levels of existing debt. So, identifying those businesses that have scarce and attractive physical assets but low debt levels will be the key to benefiting from this new emerging trend, and this has been a key focus of our investing activity.
“We have been building positions in US pipelines, airports and railroads globally to complement our existing positions in paper, steel and other hard-asset businesses in recent months.
“These companies appear lowly valued but should benefit both from a strong economy in the short term and, more importantly, position the fund to be defensive against potentially rising inflation and interest rates in the long term.”
Jane is not the only fan of capital-intensive businesses. In a recent interview with FE Trustnet, James Henderson, manager of the Lowland Investment Company, said he favours industrial stocks due to the wide barriers to entry and pointed to Rolls-Royce as an example.
“People say Rolls-Royce has got a problem with the Trent engine at the moment, but one, it will sort this, and two, this is an incredibly complex and difficult thing to create and build,” he explained. “That gives you an advantage and a position that people don’t take on.
“How many millions of miles has the Trent engine been flown in tests? Boeing’s Dreamliner is the long-haul plane you will fly in for the rest of your life; it may replace it in 40 years’ time, but my point is it’s a hell of a long cycle.”
Performance of fund vs sector over 5yrs
Source: FE Analytics
Data from FE Analytics shows that Jane’s MI Miton Cautious Monthly Income fund has made 39.05 per cent over the past five years, compared with 28.11 per cent from its IA Mixed Investment 20-60% Shares sector.
The £296.6m fund has ongoing charges of 0.86 per cent and is yielding 3.98 per cent.