In recent years, asset managers have had little to worry about when it comes to inflation, which has been at low levels for more than two decades. According to figures from Eurostat compiled by Trading Economics, the EU’s inflation rate averaged just 1.88 percent between 2000 and 2021. The highest rate ever reached in the more than 20-year period was 4.5 percent in July 2008, shortly before the eruption of the global financial crisis.
Today, inflation remains relatively low at 2.5 percent in July 2021 in the EU but has been steadily creeping up from the low level of 0.2 percent seen in December 2020. Numerous factors could be pointing to an ongoing inflationary period, meaning private markets managers will need to consider how this might impact their portfolios.
At present, the consensus among asset managers is that we are not likely to see a paradigm shift in inflation and that recent rises are simply a post-pandemic ‘catch-up’, but there is a sizeable minority who believe we could be facing a more structural shift.
“We are mindful and concerned about inflation,” says Anthony Robertson, managing partner and chief investment officer of Cheyne Strategic Value Credit. “We have a combination of supply constraints, labour cost inflation and general price inflation across a multitude of sectors and this could be more permanent than markets are currently giving credit.”
John Zito, deputy chief investment officer of Apollo credit, says “certain parts of the US and the economy are starting to really feel inflation, especially areas like south Florida and in Texas where you’ve had a huge influx of people driving up demand”. Moreover, he notes “it’s still unclear whether many people who aren’t currently participating in the labour market are going to return to work”. Apollo’s positioning is that it may be “much more difficult than people think” for the next six months.
One outcome of the covid-19 pandemic that could have a significant long-term effect on inflation is the amount of government spending that has been required while large parts of many economies were shut down in an effort to contain the spread of the virus. Many countries have also committed large sums to their health systems to enable them to cope with increased demand during the pandemic.
“We have a combination of supply constraints, labour cost inflation and general price inflation across a multitude of sectors”
Cheyne Strategic Value Credit
“Given that large public sector balance sheets have inflated significantly, we have to ask if this will be a short-term trend,” says Emmanuel Deblanc, head of private markets at Allianz Global Investors.
“And if we don’t get inflation then what else? Will governments try to recoup their indebtedness with higher taxes, for example?”
Many lenders including private debt funds typically structure loans with floating rates, which in theory should help protect them from increasing interest rates as a result of inflation and mitigate any impact on real returns. But this does not mean risk is eliminated.
“As rates increase, will that stress the servicing of the debt?” asks Deblanc. “The big challenge for lenders would be if there was a sudden shock and change in the inflation paradigm.”
Fortunately for private debt lenders, sudden shocks can be accommodated, as typically investments are over longer time periods. However, for fund managers nearing the end of their investment period, a sharp increase in inflation could impact real returns to investors.
A sudden inflation shock at precisely the wrong time can be particularly difficult to combat, and managers may wish to anticipate this risk by investing their portfolio in areas where inflationary pressures are less likely to affect their returns, for example avoiding industries that are heavily impacted by the rising prices of materials.
The effect of inflation on private equity investors is also relevant for private debt funds given the PE industry is still a major user of private credit. While inflation of below 3 percent is unlikely to have much impact on private equity investments, the potential for inflationary pressure to trigger a recession could make underwriting more challenging for PE deals and result in a slower pace of private equity deployment, which would have a knock-on effect for private debt dealflow.
Despite these risks, Deblanc believes that a higher inflation environment is likely to be beneficial overall for private markets.
“Inflation is an opportunity for private markets, broadly speaking,” he says. “The long-term nature of private markets investments coupled with the ability to absorb or pass on increased costs should enable private markets strategies to provide protection against inflation and provide investors with the yield they need.”
Deblanc concludes that, given private markets have already performed strongly through a long period of low inflation, investors should be well positioned to benefit from any new era of higher inflation ahead.
But what if the real worry is not inflation, but disinflation – or even deflation – in a slowing economy that is at risk of another recession? In the US, some are giving this serious consideration.
Granted, it’s a fairly contrarian perspective, given the spike in producer and consumer prices in the spring and summer, and some indications of tightness in the labour market. But if the covid-19 pandemic has taught us anything, it’s that the virus, and the efforts of the Federal Reserve and Congress to mitigate its economic effects, is creating significant distortions in the data that are likely to moderate now that the fiscal stimulus cheques have been spent and the government withdraws some of its other supports.
The view that the recent bout with inflation has, indeed, been transitory, is held by one high-profile economist, David Rosenberg, a Wall Street veteran who founded his own firm, Rosenberg Research, shortly before the onset of the pandemic in the US. He has maintained for some time now that a run-up in prices in the US would be a passing phenomenon, one that was created by massive fiscal stimulus coinciding with a rapidly reopening economy amid pandemic-related supply constraints.
“There’s no question that we have an inflationary situation caused primarily by the disruption in the supply chain,” Rosenberg says. But he sees supply constraints easing over time, and consumer demand tailing off. He notes that spending intentions on home and auto buying are down to 40-year lows. Moreover, spending plans for big-ticket durable goods are heading back toward where they were in 2008.
Just a hiccup
Federal Reserve chairman Jerome Powell, speaking at the Kansas City Fed’s annual conference in late August, said that inflation is not broad based, and that “it seems unlikely that durables inflation will continue to contribute importantly over time to overall inflation”. Moreover, the US central bank’s preferred measure of inflation, the percentage change in the deflator for core personal consumption expenditures over the trailing four quarters, has averaged 1.6 percent since the Fed posted its 2 percent target in January 2012, wrote Alan Blinder, a Princeton University economics professor and a former vice-chairman of the Fed, in an opinion piece in The Wall Street Journal last summer.
“We’ve already had the inflation hiccup,” Rosenberg asserts, adding that it could last a few more months. Now that 90 percent of the massive fiscal stimulus has been spent, premium jobless payments to unemployed workers have stopped, a federal moratorium on evictions has ended and the Delta variant is subduing spending on travel and leisure, the risk is that aggregate demand – which Rosenberg says is “slowing at an alarming rate”, will flow below aggregate supply, triggering a renewed disinflation cycle. “People tend to forget that the last time inflation was running this hot was in the summer of 2008,” the economist says. “A year later, year-over-year prints had swung into negative territory.”
Strategists at AlpineMacro, another independent investment research outfit, also belong to the deflationist camp. “A potential surprise for financial markets could be a whiff of deflation later this year or in 2022,” according to one of the research group’s special reports published in mid-August. The researchers recommend that “investors should bet on the inflation breakeven rate falling rather than rising”.
A major counterbalance to inflationary trends is the secular uptrend in productivity. “The one thing the business sector had to do to survive the pandemic was to work smarter,” Rosenberg says. For all the talk of a shortage of workers and a wage spiral, “the reality is that we’re producing more than we were at the previous peak before the pandemic with 5 percent fewer workers”.
These productivity improvements will help contain unit labour costs, which Rosenberg calls “the mother’s milk for inflation”. In addition to disruptive technology, which also will increase productivity, long-term trends such as the aging demographic and the massive volumes of debt will constrain aggregate demand and will help to contain inflation, Rosenberg says.
Contrary to the pronouncements of some pundits, the current situation bears little resemblance to the runaway inflation of the 1970s, when unions were flexing their muscles and unit labour costs increasd by 10 percent. What distinguished the 1970s from any other decade, Rosenberg says, was the “virtual absence of productivity”. Meanwhile, both Rosenberg and AlpineMacro point out that there was a confluence of massive economic shocks in the 1970s. Among them was the breakdown in the Bretton Woods system – the key anchor to price stability following the second world war – which AlpineMacro called “a once in a lifetime shock to the US economy”. Also unique to that decade were the end of the gold standard, which led to the dollar depreciating 95 percent against gold, and several huge oil shocks which Rosenberg says led to a tenfold increase in energy prices.
This time around, the monetary system hasn’t imploded, and oil prices, after skyrocketing to $100 a barrel in early 2020 on a price war and cuts in production, have since declined by about one third. The commodity complex, which led the reflation trade a year ago, is in reverse, Rosenberg wrote at the end of August, with lumber at a 13-month low, and iron ore at an eight-month low. With Rosenberg Research’s S&P 500 inflation index peaking in mid-May and falling by nearly 10 percent by the end of August, the stock market seems to be reflecting fewer concerns about developing inflationary pressures.
Inflation also has been contained in goods and services. In one of his daily research reports in early September, Rosenberg noted that some 60 percent of the components of the July consumer price index – including rents, groceries, home improvements, pharmaceuticals and medical services, among others – were running at an inflation rate below 1.5 percent. Consumer inflation, he says, is being caused largely by the automotive sector, which is sensitive to the chip shortage, and by the rebound in airlines, hotels and entertainment, after the “pernicious price carnage” in 2020.
But in September, airlines began warning that the Delta variant was starting to impact travel, and that it likely would pressure third-quarter results. And Bank of America economists noted last month that a massive covid wave and lockdown in Malaysia, which plays an outsized role in the manufacture of semiconductors that are used in autos, had curtailed chip supply. But they added that vaccination rates have improved significantly in Malaysia, and “the peak disruption is likely behind us”.
Moreover, if inflation is really so problematic, why has the bond market rallied since March? “The secular bull market in 30-year Treasury bonds remains fully intact,” according to Rosenberg. He is not alone. Rick Rieder, head of fixed income at BlackRock, the world’s largest asset manager, was quoted in The Wall Street Journal in May as saying that he didn’t expect the pandemic recovery and fiscal stimulus to result in inflation that ends the long bull market in bonds. “We don’t think inflation is going to be that high for a persistent period of time,” he said.
Rosenberg expects that in a year’s time, the yield on the benchmark 10-year Treasury note will be lower than its recent 1.30 percent. So far, he’s been right. While pundits were wringing their hands back in March about yields on the 10-year shooting up to 1.75 percent, Rosenberg was coolly predicting that yields would decline. Sure enough, they fell to 1.1 percent in July, their lowest level since February, on fears that the Delta variant would create a drag on the economy, before settling back to their recent range.
And the breakeven levels on the 10-year Treasury Inflation Protected Securities, or TIPS, sit below 2.3 percent, where they have remained more than 75 percent of the time since inception in 2003, writes Rosenberg. He notes that this is the level TIPS hit in July 2008, “just as we were going into a new chapter of the housing crisis and financial sector meltdown”. With 10-year inflation expectations under 2.3 percent despite all the fiscal and monetary stimulus, “Mr Market is telling you that if anything, it is that deflation, not inflation, is the principal future risk”, Rosenberg wrote in late August.
Some economic indicators are pointing towards a significant slowdown in the economy. Heading into the August report, retail sales were poised to have declined for four consecutive months, a situation which in the past “has only occurred in the context of the economy heading into a recession”, according to Rosenberg. He also cited a report from the Economic Innovation Group in mid-September that noted revenues had fallen at one quarter of US small businesses in each of the past three weeks, while only 8 percent saw any revenue growth at all.
“The economy is on the precipice of double dipping,” Rosenberg says, although he cautions that we may not go into an official recession. The risk to his view is not that we have a sudden reacceleration of aggregate demand, but that he has overestimated the salutary effects of productivity on the economy and underestimated the tightness in the labour market, and that supply constraints “prove to be more pernicious and sustained” than his current expectations.
Nevertheless, he is forecasting a weak economy with low inflation. “A year from now the inflation rate is going to vanish,” he says. And he expects the air to come out of the markets as well. “The Fed’s actions have propelled insane valuations across virtually every asset class,” he says. On that score, “there will be a day of reckoning”. That, rather than inflation, could be the biggest concern for alternative assets and other areas of investment.
Another chance for private debt to prove its resilience
The asset class is gaining a reputation as a strong performer in times of trouble
Prior to the outbreak of covid-19, many in the market were pondering how private debt would fare in the face of a crisis. Since maturing as an asset class in the aftermath of the global financial crisis, it had arguably enjoyed favourable economic tailwinds and not really been put to the test. Since the pandemic first struck, views have been generally favourable – private debt firms have been applauded for helping to support companies through challenging times and, as yet, distress signals within portfolios are few and far between.
A new paper from private markets specialist Adams Street Partners makes the case that private debt is well placed to put another feather in its cap by successfully coping with any inflationary impact. Among the points it makes are:
1 Private credit continues to exhibit strong performance even when market conditions are generally unfavourable, with Adams Street seeing yields 270-300 basis points above those available for credit alternatives in the high yield and leveraged loan markets.
2 Record levels of dry powder, low interest rates and high valuations have spurred a significant uptick in dealflow, which has helped dampen the effect of increased competition and kept spreads relatively strong.
3 The floating-rate nature of private credit means that the asset class is well suited for potential inflation or a rising rate environment.