Growth versus inflation: how will central banks react to rampant price rises and mixed economic data?

At first glance, rising inflation may seem like a relatively simple problem to fix. Central banks, such as the Bank of England and US Federal Reserve, would raise interest rates to curb demand for goods and services. This would, other things being equal, lead to a lower rate of inflation.

However, the situation regarding inflation is, unfortunately, slightly more nuanced. Recent economic data has been mixed. While US industrial production continues to expand, it has been held back in recent months by supply issues. Moreover, US consumer confidence has dipped following a period of buoyant mood. And, with positive economic surprises being less plentiful than they were six or 12 months ago, the prospects for the global economy may be starting to show signs of a slowdown.

Since a rising interest rate would normally be expected to cool economic growth, central banks may decide to adopt a ‘wait-and-see’ approach to inflation. As well as determining that elevated levels of inflation are likely to be temporary due to the one-off effects of post-pandemic economic reopening, central banks may be able to justify maintaining low interest rates based on several other factors.

For example, they may highlight that low interest rates provide support to employment levels and asset prices by catalysing economic growth. Furthermore, they may suggest that low interest rates aid the shift to a low-carbon economy by providing cheap finance for major renewable energy projects.

Of course, higher inflation could also be blamed on supply bottlenecks in specific industries. Central banks may even try to claim higher inflation is an overall positive because it suggests the economy is ‘running hot’ and providing wage growth.

However, in reality, low interest rates are providing cheap money that is raising demand for scarce resources. This is pushing their prices to increasingly high levels. Meanwhile, rising wages are of little benefit if they lag inflation and therefore fail to provide greater spending power.

In terms of portfolio positioning, continued low interest rates could strengthen the prospects for risky assets. For instance, the current bull market in equities could continue based on rising earnings as economic growth continues.

We expect structurally higher inflation, however as the current impulse of central bank financed government spending fades, current levels of inflation may appear to be transitory in the short term. Inflation may even subside in the coming months, taking a pause before rising in a second wave.

Our portfolios remain positioned for a persistent inflationary environment, holding companies that can successfully pass their rising costs through to consumers to maintain profit margins.

The recent United Nations COP26 summit placed further pressure on companies to demonstrate how they intend to reach climate change targets. Here at Sanlam, we believe our sustainable approach to investing can also make a difference.

As long-term investors, we seek to buy and hold high-quality businesses, for which sustainability is a key factor. Defining whether a company is sustainable or not is subjective and investors frequently disagree. Our investment process analyses all the risks to a company from its environmental activities, its social policies, and its governance structure. Additionally, we apply three key principles to all investments we make.

The first is related to whether a firm seeks to minimise the environmental impact of its operations. This may include plans to reduce plastic use, install solar panels on buildings and implement energy efficiency plans, minimise chemicals and pollutants in manufacturing processes, or even provide solutions to help other businesses improve. As the world transitions to greener methods of production it is important that companies are responsibly run, and significant investment opportunities stem from facilitating the transition.

The second requirement focuses on the social impact of a company. Companies that solve society’s problems and make the world a better place naturally earn stronger profits as people are often keen to pay for things which improve their lives. Additionally, the consumer reigns supreme, and can withdraw its consent by refusing to buy from companies which behave contra to society’s principles. As a result, businesses such as tobacco companies and gambling firms do not qualify under our process.

Our third consideration centres on a company’s corporate governance. We seek out firms with honest and credible management teams that are willing to engage constructively with shareholders to ensure interests are closely aligned. The key to a successful investment is a management team that can successfully execute their business plan.

Some companies may have a mixed track record in specific areas within the environmental, social and governance (ESG) arena. However, they could be in the process of implementing a greener, more ethical and more responsible strategy. In which case we would support this as investors, potentially investing to benefit from the improvement.

As well as using robust criteria to identify sustainable businesses and companies that have the potential to become more sustainable, we have an in-depth process of implementation and review. ESG considerations form a key part of the initial process and ongoing due diligence undertaken by our research analysts when considering specific companies for investment.

Once a company is purchased, we seek to regularly engage with its management to represent our investors’ interests as shareholders. We also vote as shareholders to ensure sustainable business practices continue to be adopted and followed. This forms a central part of our ongoing monitoring of portfolio holdings to ensure they are implementing the ESG-related strategies that initially led to their purchase.

Clearly, there will be occasions when a company’s actions do not align with our requirements on ESG matters. Where such actions create risk to the investments we withdraw our capital.

Of course, our focus on sustainability does not mean we lose sight of the importance of other factors when assessing the appeal of specific companies. Indeed, a detailed assessment of areas such as growth prospects, financial strength, profitability, and a strong and enduring competitive advantage are key parts of our investment process. ESG considerations are woven through all stages of our investment process, and are important in identifying risks that may not be captured in financial metrics as well as building conviction that the company is a high-quality business worthy of purchase for our clients.