Ready for a reflationary world? Investors underestimating return of inflation

Investors need to prepare for a shift to a reflationary environment globally after more than a decade of deflationary pressure, with the impact from the financial crisis now finally at an end, River and Mercantile Asset Management’s Hugh Sergeant has said.
Sergeant, manager of the £455m River and Mercantile World Recovery fund, said inflation had diminished aggressively in recent years, during which time developed market bonds had reached multi-generational peaks as investors focused on deflation instead.
However, the backdrop is now changing significantly, with the sharp decline in output caused by the global financial crisis almost completely gone, leaving spare capacity in the advanced economies at the lowest levels seen for eight years.
“As the global economy moves through this period of synchronised growth so will the spare capacity that has existed since the financial crisis continue to be eroded,” Sergeant said.
This erosion means a move to a reflationary cycle is now taking place, but Sergeant said this remains significantly underestimated by markets, and therefore creates a number of opportunities for investors.
“We have long argued that the world economy would at some point shift from deflation to reflation,” he said.
“With the investment consensus still locked onto deflation, such a reflationary shift would have quite an impact, and indeed this has now begun and in its initial phase it will be relatively benign and supportive of equity prices.”
Sergeant and the team use the PVT (Potential, Valuation, Timing) investment process across River and Mercantile’s range of equity strategies to appraise a combination of factors in order to find opportunities for the portfolios.
In the current environment, as the shift to reflation starts to take hold, Sergeant said PVT is flagging a switch from bond proxies and guaranteed growth stocks into a broad set of PVT opportunities with value stocks performing much more robustly than they have in recent years.
“The beneficiaries of the turn in the economic cycle include recovery stocks, commodities, banks and regions of the globe which have lagged this cycle, such as the UK and emerging markets. We are well positioned for that shift,” he said.
The fund has positions in names such as Lloyds and Standard Chartered within the UK’s financials sector, while it also holds miners including Anglo American and BHP Billiton. Further afield in emerging markets holdings include Tingyi.
It has also been investing in names with exposure to the digital economy which have become unloved by the wider market. As a result, the portfolio has recently increased its exposure to companies such as MercadoLibre and Baidu in emerging markets, as well as Blue Apron in the US and SoLocal in France.
Sergeant, who launched the World Recovery fund five years ago, significantly outperforming the broader market and competitors, added that the recent correction has left his favoured stocks looking even more attractive.
“We have had a correction which removes some of the froth, and quite a few buying opportunities have emerged at a stock level in the sell-off. We don’t think the market wobble significantly impacts the real world and our synchronised growth thesis remains, particularly for the reflation names.”
Since launch in March 2013, the fund – which has maintained its PVT philosophy throughout – has returned 121.9%, versus the IA Global sector average return of 66.9%, according to data from FE Trustnet[1].
[1] FE Analytics (as at 09/03/2018) – River and Mercantile World Recovery Fund Class B 121.9% vs 66.9% IA Global sector average since inception