Back in March I thought that the prospect of my portfolio reaching new highs again within three months was outside the realms of possibility. This resilience in the face of a very severe economic contraction likely has something to do with expansionary government policies, in particular the huge injections of liquidity into financial markets by central banks. But has this really ‘solved’ the issue? 

One thing I was concerned about when I was at my most pessimistic was that the economic contraction would have knock-on effects on consumer confidence and business investments decisions. If consumers take a long time to start spending again and business decisions to make capital investments are delayed, we might be in for a much slower and more painful recovery than the V-shape currently anticipated by some. I think it’s still too early to say much about these knock-on effects or what shape the recovery will be. More importantly, in hindsight I think my concerns were naive. I underestimated the impact of government policies in inflating financial markets and neglected to account for the distinction between high quality technology stocks, which are benefiting from the current environment, and cyclicals, which are suffering along with the wider economy. 

However, the huge debts being accumulated and vast sums of money being created to prop up the economy lead to other long term concerns. Macro-pundits seem to be divided on whether we should be more worried about a deflationary spiral, as has blighted the Japanese economy since the 90s, or excessive inflation, like we had in the 70s. While I think macroeconomics is largely an unhelpful distraction from an investing perspective, it’s sufficiently intriguing that people are simultaneously worried about both of these opposite scenarios that I’ve had a think about this myself.

The deflationary scenario is what might transpire if consumer demand remains weak, even after the supply side of the economy is back up and running. Excess supply over demand leads to deflationary pressure as businesses are forced to cut prices to survive and workers compete over fewer jobs. The real long term risk is if falling prices eventually lead to a self-fulfilling deflationary spiral, where expectations of further falls in prices lead people to start saving more rather than spending. Deflation is more of a problem when there are high levels of debt. Debt becomes increasing hard to service if prices and incomes are falling in nominal terms.

The inflationary scenario is what might happen if the government’s monetary response ends up being excessive. Expansionary measures like quantitative easing have increased the money supply, both on bank balance sheets and in the real economy (unlike after the Financial Crisis where a much smaller scale of QE was almost entirely absorbed by a banking sector in desperate need of liquidity). While this money is sitting in business balance sheets and consumer bank accounts there is no problem, but once the economy starts picking up again and the velocity of money circulation increases we will end up with a much larger supply of money chasing the same supply of goods and services. This leads to inflation. Just as expectations of deflation can lead to more deflation, expectations of inflation can be self-fulfilling too. There are no shortage of examples of where overly expansionary government policies have led to hyperinflation.

Either scenario would be bad for investors but which is more likely? It seems to boil down to two fundamental questions: how quickly and to what extent will consumer demand recover? How is government policy going to respond?

It seems incredible that new social distancing measures are still being introduced or re-introduced five months on from the peak, when daily deaths from Coronavirus have fallen by more than 95%. Hopefully this won’t go on much longer. Lock down policies have discouraged consumers from leaving their houses or spending money. It’s likely that some of the change in consumer behaviour will become permanent as new habits are developed. The main long term impact is going to be a permanent increase in the rate at which the economy is shifting towards online, building on the massive acceleration that has already happened. While consumer demand might take some time to fully recover to pre-pandemic levels and the effects of high unemployment are yet to be felt, I’m skeptical that there is going to be a permanent change in consumer behaviour towards saving more. 

It’s also pretty clear that government policy will be strongly biased towards inflation over deflation. This makes a lot of sense as towers of debt are being built. Central banks have signaled very clearly their intent to do whatever it takes to keep the economy and financial markets going. Interest rates aren’t going up any time soon and we are likely to see more QE while the economy recovers and even more so if the economy falters. 

Overall, I’m more worried about inflation than deflation in the long term. However, I don’t think there is much to worry about yet. A degree of inflation would actually be a positive. It’s only when expectations of accelerating inflation are formed that it starts to become a problem. It will likely take several years to get over the more immediate deflationary pressures in the real economy and for any inflationary expectations to develop. 

In the meantime the environment looks positive for investing in digitally focused growth stocks. They are benefiting from a double whammy of the rapid acceleration in the secular shift online and expansionary monetary policy. The conditions seem ripe for an extended bubble. Eventually valuations will become too high or inflation will rear its ugly head but I think this is still some way off.

I have a couple of trades to update on. Three weeks ago I sold Netflix for a modest profit after some mildly disappointing results. I still like the business long term but the valuation is high so felt caution was warranted. It goes back on the watchlist for now. I replaced it with Match, which has pleasingly shot up pretty quickly following positive results. I’ve held and written about Match previously.

This week I sold Canada Goose for a small profit. Momentum has been flagging and I’ve lost a bit of confidence in the imminence of its recovery after several updates from other luxury brands were worse than expected. I replaced it with Impax Asset Management.

Impax Asset Management

Impact is an asset manager specialising in ESG-oriented investments, ‘arising from the transition to a more sustainable economy’. I’ve almost invested in Impax a couple of times in the past but had last minute doubts about whether it has enough of a competitive advantage to merit a place on my watchlist.  I still have these doubts to some extent but given the profitability and scaleability of the business I think the risk reward looks good.

Quality

• Business economics: Impax has good economics. It is capital light, generates load of cash and has decent margins and returns on capital, as you’d expect from a fund management business.
• Track record: Impax was founded in 1998. After stagnating for a few years in the aftermath of the dot.com crash, Impax has grown steadily to become a £500m business. The record over the last 10 years or so has been excellent, with steadily growing revenues and profits.
• Competitive advantage: this is the weak point. Asset management is a highly competitive market. There is very little to stop investors withdrawing funds and reallocating them to the next best thing when an the offering gets a bit stale. Staff don’t find it too difficult to jump ship either. Because of this many asset management businesses seem to come and go. I’d say only the very largest asset managers, such as BlackRock, or very specialised ones have much competitive advantage from their brands or distribution arrangements. It’s not a sector that I’m very keen on, but I do make the occasional exception. What I like about Impax is that it has a niche focus in an area likely to experience secular growth for some time yet – ESG investing. This may allow Impax to develop some advantage over time through its brand, reputation and distribution, but this is far from proven and not especially difficult to replicate.
• Growth prospects: the growth prospects look excellent. The business is highly scaleable and should benefit from a favourable ESG investing trend for some time to come.

Price

Momentum is excellent. The last results were good and the price is close to breaking out to new highs. The valuation looks very cheap compared to other businesses on my watchlist experiencing similar high growth. However, this is at least partly warranted by the higher risk, lower quality on offer here.