Ep. 58 The Long-Short | Sticky inflation: The beginning of a new era?

Published: 29 March 2023

The Long-Short is a podcast by the Alternative Investment Management Association, focusing on the very latest insights on the alternative investment industry.

Each episode will examine topical areas of interest from across the alternative investment universe with news, views and analysis delivered by AIMA’s global team, as well as a host of industry experts.

Initial arguments that inflation would be transitory in 2022 have given way to the view that we are beginning a new economic cycle characterised by persistently elevated interest rates, inflation levels and consumer prices. But, does this present an opportunity for active managers to shine?

Henry Neville, Portfolio Manager at Man Group, is back in the studio to break down what inflation means for individuals and asset managers.

Henry outlines the types of strategies and assets that his models suggest will do well or poorly in the new environment and lays out the dilemma facing the Fed and other central banks looking to tackle inflation while avoiding a recession.

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Additional resources:

The Long-Short episode 18: Inflation is rising. Now what?

AIMA Journal, edition 133: Lessons from th 1970s, Henry Neville, Portfolio Manager at Man Group


Read the transcript 

Hosts: Tom Kehoe, AIMA, Drew Nicol, AIMA

Guests: Henry Neville, Portfolio Manager at Man Group

Interlude: Lorna Barnard, AIMA

Tom Kehoe, AIMA  00:05

Hello and welcome to The Long-Short. Inflation is back making headline news with the announcement this week that UK inflation accelerated unexpectedly in February. The annual rate of CPI inflation in the UK rose to 10.4% last month, higher than the 9.9% rate forecast by economists.

Drew Nicol, AIMA  00:22

The past 12 months have seen us all feeling the pain at the tills and the petrol pumps as well as forking out for higher energy prices and say nothing of the real value of our wages being hit.

Tom Kehoe, AIMA  00:33

Higher inflation is not just a concern in the UK, of course. The Eurozone annual rate of inflation stood at 8.5% last month, prompting the ECB to raise rates across the Eurozone by another 50 basis points while US inflation reached a peak of 9% last June seemingly under control now with the news that inflation has slowed to 6% annual rate last month, although we are by no means out of the woods there with the breaking news that the US Fed has increased its benchmark rate by a further quarter of a percentage point.

Drew Nicol, AIMA  00:59

So, the million-dollar question here is how much longer is this period of inflation going to last? Are we just going to have to get used to higher prices and overall higher inflation and interest rates? What options are available to savers looking to best navigate through this period? To answer all these questions and more, we are delighted to be reunited in The Long-Short studio by Henry Neville, who is a portfolio manager at Man Group.

Tom Kehoe, AIMA  01:23

Henry, welcome back. So, it's been quite a year since we last spoke with you. What is your read of the economic situation globally? And how is that impacting inflation levels?

Henry Neville, Portfolio Manager at Man Group  01:33

Thanks very much, both for having me back. Enjoyed it last time. I’m sure, I will do this time as well.

So, at the start of this year, our outlook piece or global strategy outlet piece was entitled, ‘it's all going to be okay’. And when I look back at it from this juncture, I think, well, partly that was wrong. In terms of, we've had the largest bank collapse since 2008. We've had the largest drop in the two-year yield since the late 1980s. But at the same time, develop markets stocks are up 3%, and develop market bonds are also up 3%. And I do feel that there has been a noticeable calm down from the market conditions that we experienced last year, the events in the banking sector recently notwithstanding. And when we wrote that piece, at the start of this year, our view was that although there were significant problems in the global economy and global markets, 2023 was actually going to be a year where inflation rolled over, and where the Fed was able to pause. Therefore, for it to be a pretty good environment for risk assets. And those problems that I refer to, were to be stored up for 2024 and beyond. And broadly, that's still where we are today. So, we wrote that piece, we expected US inflation to trough at 2%. Various things have meant that we now expect that trough to be a little bit higher around 3%. We expect that to happen towards the middle of this year, probably just in the middle of July. That puts us in a disinflation quadrant of our framework, which I discussed last time, I won't go through it in detail again now, but that tends to be a good environment for risk assets.

Now it is true that the other legs of our process; growth, valuation and sentiment, do not look so propitious. Growth metrics almost universally look unattractive, most notably in their inverted yield curves. Valuation depends on geography and sector, of course, but certainly, in the US, still looks expensive. And the sentiment is kind of pointing in neither direction as we measure it. But we have a situation today where we've had a financial crisis of sorts in SBV and then Credit Suisse, and monetary policymakers in general have acute muscle memory of systemic financial risks. We think this very likely slows them down on their hawkish bent and we've already seen that in the Fed, 50 basis points was odds on priced in a couple of weeks ago, they ended up doing 25 basis points yesterday and the language skewing dovish, that language about ongoing increases taken out. And therefore we think the next few months could be pretty responsive for equities. Albeit will be over the long term, as I've already referred to, we're much less sanguine.

Drew Nicol, AIMA  04:54

Henry I know you're more US-focused but I can't help but bring up this rather striking figure that came out as part of the UK Chancellor Jeremy Hunt's budget announcement last week, which was the view by the UK Office of Budget Responsibility, which forecasts that headline inflation levels in the UK could get down as low as below 3% before the end of the year, which stuck out to me and many others at the time.

That seemed like a bold prediction then and even more so now given, as Tom mentioned, in the introduction, that UK inflation for February has ticked back up into double digits, which I think wrongfooted a few people. Can I just get your immediate reaction to that figure and whether you think that can be applied to a broader trend across developed markets?

Henry Neville, Portfolio Manager at Man Group  05:45

So, we're definitely surprised by how sticky inflation has been so far this year. At the start of the year, our models were suggesting by this point, headline inflation in the US will be 5%, and we're at 6%. But the direction of travel, as I've mentioned, is still the same. And a point I always reemphasise, it seems very obvious, but it's not well enough understood in my mind, is the heavy lifting that the base effect is going to do for all countries. So, if we take the US as an example, even if we get 0.4% month-on-month readings persistently every month from here, and by the way, 0.4% a month is the 66th percentile reading going back over 100 years. So, that is a punchy number. We will still get to 3.2% year on year by the June reading.

When Prime Minister Rishi Sunak says he's going to halve UK inflation, well, even if he sat on his hands and did nothing he would very likely halve UK inflation. Added to this, there is now evidence that a bunch of the underlying indicators we look at give us a read on inflationary pressures and are starting to roll over. So yes, I do still have confidence that we're going to get fairly pronounced rollovers in the year-on-year inflation numbers in the next few months.

Tom Kehoe, AIMA  07:14

Henry, what factors can you point to, which suggest that the higher inflation levels that we're witnessing now are starting to get under control?

Henry Neville, Portfolio Manager at Man Group  07:24

So really, to understand inflation, you need to understand nine things which I'll briefly list: Energy, for obvious reasons, hard commodities, both because its key input into a number of manufacturing processes and also because its input into housing, cars, semiconductors, freight, rental costs, food, cotton, and wages. And if I just briefly run you through some of the things we look at to try and get some gauge of these. In terms of energy costs, if you look at a bunch of energy futures contracts weighted according to average US consumption, that basket is down about 20% on a year-on-year basis. And if you follow the futures curve through the next 12 months, it suggests that on a year-on-year basis, it will stay negative for the next 12 months.

The American Automobile Association's price at the pump series has been rolling over since the middle of last year and is in negative space on a year-on-year basis. Hard commodities are deeply negative, about -20% year-on-year, again, the futures curve suggests we're going to stay negative much for the next 12 months. The Manheim Used Vehicles Index, the recent numbers have moved up a bit, but on a year-on-year basis, we're still about -10%. Semiconductor prices are hard to get an exact read on but if you look at the estimated 12-month forward sales for listed semiconductor firms, those are significantly down, getting on for 10% on a year-on-year basis, the movement in that metric. Shipping costs, various metrics you can use but Baltic Dry Index is down significantly year-on-year, down about 50%. Housing costs are still positive of course, but rolling over sharply, the Zillow Rental Index which we watch was +15/16% in Q2 of last year, and it is now getting on towards +5%. Food is still expensive and is still rising quite fast rising close to 20% actually in the US but the futures curve for various agricultural commodities contracts suggests we move negative for the next 12 months. We've seen recent good headlines around the elongation of the Black Sea grain dill, for instance, over in Ukraine. Cotton, key for clothing is deeply negative and on a year-on-year basis with the futures curve suggesting we stay there for the next 12 months.

Wages, of course, the final piece. This is the one which has been higher than people expect and probably the thing which has been keeping inflation somewhat sticky, but even there you see some pretty good signs. The Jolts Quits rate, which we think is very important in the US, was 3% in the middle of last year, it's now down to 2.6%. And within the labour market, you're seeing services sector wages rolling ahead of manufacturing wages, which is key for inflation because services sectors are more labour-intensive than good sectors.

And then in particular, we watched the Atlanta Fed series on wages for people who stay in their jobs versus wages for people who leave their jobs. People who leave their jobs tend to get paid more. I'm hesitant to say that I've been at Man Group for seven years which suggests I'm a bit of a mug, but that is a fact of life. But in recent months, since COVID really, the gap between people who change jobs and people who stay in their jobs has widened dramatically. And that has been a sign, we believe, of increased labour bargaining power, and that spread is now starting to narrow. We think that is a good indicator that whilst wage growth is going to stay materially positive and we may come onto this later, more positive than we experienced in the last decade, we do think it's going to moderate such that inflation readings, over the next few months. will come down, as I suggest.

Drew Nicol, AIMA  11:51

An interesting feature of the particular period that we're going through is that, as you mentioned, several factors are ticking down. But we don't seem to have seen that filter through to prices, they seem to have gone up very quickly, but maybe not have come down in line with some of the year-on-year declines that you've just outlined there. Obviously, a bit of an impossible question, but can you just speak to why that is and when we may see prices finally return to previous levels?

Henry Neville, Portfolio Manager at Man Group  12:26

So, in terms of the reasons for it, I think it's partly that the wages piece has been stickier than we imagined. I think it's also a case that in the initial aftermath of COVID, near the initial inflationary shock, companies were unwilling to pass price rises on to consumers, partly because it's just a bit of a bad look. There's a war going on and you're seen to be price gouging, partly because psychologically, the consumer hadn't been warmed up to the idea of inflation. Now the consumer has very much warmed up to the idea. We think it's likely that there's an increasing willingness and ability of corporates to pass those price rises on as they seek to preserve margins. So, that's possibly what we're seeing.

Just more widely what I would say, and this is, I suppose bad news for you, and for me and for consumers everywhere, is what can be bad news for the consumer is not necessarily bad news for the investor. And what I mean by that is, I don’t think we're ever going back to the prices we saw pre-COVID, we're never going back to the fuel bills that we saw pre-COVID, to the mortgage costs we saw pre-COVID. Now, when you say to someone, okay, your fuel bills are going to go up 10% this year, and then next year, they're going to only go up 2%. For most people, that's scant consolation, for economists for central bankers, that's a victory. It's also a victory for markets because historically, where inflation is decelerating, even if it's not making up for the sharp rises that it's experienced, that is a good time for risk. But for consumers, we should get used to the fact that a lot of these key line items in our monthly outgoings are going to be permanently higher.

Tom Kehoe, AIMA  14:32

Oh, joyful. So Henry, the Fed, you mentioned rolls its benchmark interest rate by a quarter percentage point yesterday and that's its ninth consecutive rate rise, if I've got that correct, the highest since 2007. And to put this in perspective, one year ago, rates were at historic lows and were near zero, right? So, are we then seeing the beginning of the end of the Fed's monetary tightening? Have the Fed gone far enough?

Henry Neville, Portfolio Manager at Man Group  15:21

Yes and no are the answers to those questions. Yes, I think we've seen the beginning of the end. I think it's not crazy to me that the hike we saw yesterday will be the last, certainly of this phase of the cycle. As I said earlier, there is just this acute fear, understandably, because of the 2008 systemic financial crises. I believe that, along with what I see to be softer-than-expected inflation readings over the next few months as I've detailed, is going to be enough to manifestly slow them down and perhaps even stop them. Is that enough to stop inflation over the longer term? Well, no, I don't think it is. And this is the echo, I should say that we have of the 1970s. It tends to be that central bankers do a bit when faced with inflation, but rarely do enough. And therefore, though inflation will slow down over the next few months, I believe, further such waves are likely through the next decade because rates at 5% are not enough to kill that.

Drew Nicol, AIMA  16:45

Just before we move on from central banks, we mentioned that the Fed has made its move already, at the time of recording on Thursday, the 23rd of March, the Bank of England is about to imminently put out whether it is also going to raise interest rates, how much can we assume that the move by the Fed will influence the Bank of England? Are we expecting them to all be in lockstep on this? Or can we assume that we are near the end across the board?

Henry Neville, Portfolio Manager at Man Group  17:24

Well, I’m not expecting them to be in lockstep because the inflation patterns across western economies, while they've been similar in terms of the shape of the curve, it's happened at different times. So, the UK and Europe have been somewhat behind the US, but broadly, I would expect the same pattern. Inflation pressures here in the UK are worse than in the US, but with the exception of energy consumption, have similar drivers. If the Bank of England starts cutting before the Fed, the obvious outlet for that will be in currency markets. For the UK in particular, we think that the Sterling is so cheap now on pretty much any purchasing power parity or rate parity model, the impact of that would be somewhat blunted. But broadly speaking, yes, we're expecting the same pattern, but no, not necessarily in lockstep.

Lorna Barnard, AIMA  18:38

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Tom Kehoe, AIMA  19:22

Henry, you alluded to it in your paper, I really enjoyed reading your paper ‘the lessons from the 1970s‘ and it compared the higher inflation period that we're experiencing now with the inflation environment of the 1970s. Could you take our listeners through the comparisons that you're seeing from then and now?

Henry Neville, Portfolio Manager at Man Group  19:44

Sure. So, there are some similarities in causation. In the 1970s the United States was coming out up and indeed was fighting the Vietnam War, and at the same time was faced with a large energy supply shock coming out of multiple crises in the Middle East. And today, the United States has been fighting a medical war against COVID, coming out of that, and is also faced with energy supply shocks coming out of the war in Eastern Europe. So, there are similarities and causation. We actually prefer to focus on the monetary policy angle. As I've already alluded to, inflation tends to come in waves, and when faced with those waves, monetary policymakers tend to do a bit, but not enough.

So, through the 70s, we saw three inflationary waves from October 1967, to January 1970, from June 1970, to December 1975, and from November 1976 to March 1980. If we take the second of those waves as an example because that was the tenure of Chairman Burns, who today is the go-to for someone who wants to give an example of terrible monetary policymaking. But as I suggested in that paper that you referenced, in a sense, it's a little bit unfair because Chairman Burns through that inflationary wave kept real rates positive for almost the entire period, and by an average of +1%. And in the inflationary wave, that we've recently seen, which we date from February 2021 to June 2022, the US Federal Reserve has kept rates negative throughout and an average of -6%. So, the similarities to the 1970s, we think it's very likely, even though as we say, we think inflation will moderate in the next few months, this is not the last wave of inflation in this decade.

Now, in terms of what rate they would have to go to, and this is why I said in answer to your question earlier, no, I don't think they have done enough, what rate they would have to go through to kill the beast, it's unfashionable now, but we actually still like the Taylor rule as giving a good heuristic as the rate that would permanently get them back to their 2% target. Now, for the US today, that's 9.5%, for the UK it is 12.8%. Now, I don't need to tell you, they're not getting anywhere close to that. That's why we are quite strong believers in multiple inflationary waves throughout the course of this decade.

Drew Nicol, AIMA  22:38

I should say for listeners at this point that this is an article that appeared in the AIMA Journal, which is free to download as of Monday, I believe. If you just (click here), you'll be able to see that excellent article there. And I also really enjoyed reading it, if only for the rather worrying and colourful metaphor you bring up, which is that you, as you just said, suggest that central banks need to take decisive action to kill inflation. And if they don't, you likened it to the Terminator. Given that inflation will come back in a stronger and more terrifying form. Can you just elaborate on why this was an appropriate analogy?

Henry Neville, Portfolio Manager at Man Group  23:23

Yes, I think it's human nature when faced with an unappealing choice to procrastinate. And today, the Fed is faced and monetary policymakers globally are faced with the unappealing choice of multiple waves of inflation or unemployment. And the reality is, they're not going to unanimously and deliberately pick one of those. They're going to do something in the middle. They're going to raise rates a bit, but not quite enough. And that's why we think, like the Terminator, it keeps coming back. Inflation will keep coming back over the next 10 years.

I just did some back-of-the-envelope math the other day for a different piece I'm writing, just to give you some sense of how unrealistic and indeed unreasonable it would be for the Fed to raise rates to the sort of levels we think would kill inflation outright. I mentioned that the Taylor rule for the UK is 12.8%. Today, the average UK household earns £3507 per month after tax. The average house price in the UK today is a little over £285,000. The prevailing five-year fixed rate mortgage is 4.4%. So, I won't ask you to do the math, but I did it on a spreadsheet and assuming a 75% LTV (Loan-to-Value ratio), this equates to £988 in mortgage payments per month, that's 28% of post-tax income, by the by this is comfortably an all-time high in data dating back to 1900.

Now, if we look over the long-term, the spread between prevailing mortgage rates and the base rate is about 120 basis points. So, if the Bank of England hit the Taylor rule of 12.8% that would mean prevailing mortgage rates of 14%. That means the average UK household is paying £2374 a month or 68% of their post-tax income just on mortgage payments. They are not doing that in a hurry. And that's why we think, as I said, we got going to have more such inflationary waves to come.

Tom Kehoe, AIMA  25:48

That is fascinating, Henry, and of course, that's just paying for the mortgage loan, you've got to put stuff into the house and you got to feed yourself. So, that number will be even higher still, particularly with food inflation, I saw the headlines today that food inflation is 18%! Bringing this back to investing, how should institutional investors be managing their capital at this time?

Henry Neville, Portfolio Manager at Man Group  26:16

Well, I will repeat what I said last time, my compliance department has been on a tight leash. So, I'm not going to give any advice to anyone on how they should invest their money. But, what I can say is what has happened historically, based on different environments.

The first thing to say is, if we have more inflationary episodes through the next decade, we want to know which assets perform best in periods of high and rising inflation. Historically, we wrote a whole paper, ‘the best strategies for inflationary times’ where you can get chapter and verse on what does well, but I'll give you a potted summary here. Things that do well, I'm just going to give you a few examples, commodities, and in particular energy commodities, copper, and gold, being short duration, being long energy stocks versus the market, being long miners versus the market, particularly gold and coal. albeit some people will have some ESG concerns with the latter. Being short consumer discretionary stocks versus the market, in factor terms being long, high quality, versus low quality, being long cross-sectional equity momentum, and being long large caps versus small caps. So, that is the basic shape of the portfolio you might want, if you believed in more such inflationary episodes as I do.

But I come back to the point that periods of higher inflation tend to be periods of higher volatility and inflation and periods of waves of inflation. The example of the 1970s was such that in those periods when inflation was rolling over, you actually wanted a very different type of portfolio. So, we think it's not enough just to work out what your inflation hedge portfolio is, and stick all your eggs in that basket, we think a more dynamic approach is required.

Drew Nicol, AIMA  28:36

And that tees me up beautifully for my next question which is just to say that, with volatility up, and generally, a more frothy market, does that present an opportunity for active managers at this time? What would you say are the investments that are most immune to higher inflation? You mentioned a few there, but where can people look to best place their assets to protect wealth?

Henry Neville, Portfolio Manager at Man Group  29:03

Yeah, I work for not just an active manager, but a manager at the more active end of the active spectrum. So, that disclaimer ahead of what I'm about to say, but yes, I definitely think there are periods of time in history where beta works. And there are periods of time in history, where you need to be more dynamic. Actually, if you look at the 1970s, it provides quite a good playbook for that.

So, if we go from 1967 to 1982, which is what I would call the broader period of inflationary turmoil at that time, over that full period, a US 60/40 portfolio in real terms would have returned you -3% non-annualised. So, you might think, well, great, Just be short 60/40. But actually, the volatility of returns through that time was immense. So, between November 1968, to May 1976, 60/40 was down 24%. Again, in real terms, all the numbers I'm going to quote will be in real terms. But then from May 1972 to January ‘73, 60/40 was up 39%. From January 1973 to December 1974, it was down 37%. From December 1974 to December 1976. It was up 33%. From December 1976 to September ’81, it was down 24%. And then finally, from September ‘81 to December ‘82, it was up 33%. So, that volatility, that kind of changes in episode through a broader regime demonstrated the importance of a dynamic approach to portfolio management. And we think the next 10 years could be of similar importance.

Tom Kehoe, AIMA  31:06

Henry, of course, the name of our podcast series is The Long-Short. So, it would be remiss of me if I didn't ask about alternative investments. Presumably, these will be appealing to investors as well who will be looking to navigate through this market environment.

Henry Neville, Portfolio Manager at Man Group  31:24

I think it usually depends on which alternatives you're talking about. Alternative, as the name suggests, is a somewhat diverse space. I think specific to inflation, we find that in historic inflationary episodes, trend commodities, as I've already said, certain long-short strategies, and commercial real estate tend to do well. But private equity, private credit and residential real estate tend to do badly, it's a misconception that residential real estate is a good inflation hedge because it's so exposed to the consumer. So, I think it's about not having a blanket approach and thinking carefully about which alternatives one has in one's portfolio and what one is expecting them to do.

Drew Nicol, AIMA  32:18

Well, Henry, this has been absolutely fascinating as we knew it would be and thank you for being the Sarah Connor to our Terminator and warning us and protecting us from the nightmare that is persistent inflation. But unfortunately, it's all we have time for. So, thank you so much for joining us on The Long-Short and helping us understand this sticky problem.


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