Chester Asset Management, October 2021 - Insight

The most recent COVID inspired emergency response has seen 20 years of US central bank debt accumulation double in 12 months. It is very unclear how this ever gets repaid. We have arrived at a juncture of financial repression, for governments themselves can not afford materially higher interest rates, but are effectively forced to run budget deficits, for the greater good.

The control of the supply of money is changing from central banks to governments as they grapple with the moral hazard of looking after their citizens’ way of life. The consequence of this appears to be that short term interest rates will not reflect inflation expectations and any sign of significant asset price volatility will see the effective capping of long term interest rates.

This line of thinking outlines the playbook for a decoupling of inflation and interest rates for the first time since the 1940s. This is actually a necessary policy setting to have any chance of governments solving the current debt crisis. The pathway to this outcome may not be smooth, but essentially this is the most probable scenario, given so many others (materially higher interest rates, austerity or even sovereign debt default) are far more unpalatable, with far greater social consequences.

Hence we see a problematic period ahead whereby central banks are facing the prospect of slowing economic growth, while grappling with meaningful inflation for the first time in almost 40 years. The inflation issue appears to be far stickier than most pundits had expected at the start of the year, and looks set to continue into 2022.

This challenge of unwinding the easy monetary policy settings suggests to us that uncertainty will create more volatility, and with that the desire to own a portfolio of stocks that can insulate the portfolio from significant drawdowns, while still offering strong valuation support.

We’ve made changes to our portfolio in the past quarter to find companies that will trade in a non-correlated manner to the broader market. We’re looking at a few key areas including:

  • Real assets – We believe inflation will drive real asset valuations higher.
  • Valuation margin of safety – We’re not overpaying for long-duration assets or concept stocks. Instead, we’re focused on the near-term.
  • Pricing power – We’re considering how long companies will be able to hold their prices stable before being forced to pass on inflation costs to consumers.
  • Gold – There is extreme value emerging in gold equities, as it’s the most unloved sector across global equities right now.

The current trends in markets are bringing the focus back on our core philosophies: backing ourselves when it comes to unappreciated assets, maintaining a high active share and investing in companies with strong, predictable cash flows. We seek to continue to deliver a portfolio that generates stronger alpha, with lower beta than the market.