Investment Funds: What if inflation falls more quickly?

In November, Stifel Funds thought the market consensus may be surprised at how quickly inflation falls during 2023, and investors would soon start focusing beyond peak interest rates.

Since then, we are likely to have seen the peak in US and UK CPI. A scenario where inflation falls quickly during 2023 was discussed in the Bank of England’s commentary last week. Stifel are becoming more confident in their view and have revisited the potential implications for the performance of many Investment Fund sectors for us.

Stifel Funds have listed 5 reasons why they believe inflation may fall more quickly than many expect:

1. Power price declines
2. Money supply falls sharply
3. The effect of a higher inflation ‘startingbase’ should be fully reflected by April 2023
4. Weakening US dollar is helpful to the UK in reducing commodity input prices e.g., oil
5. Weaker economies dampen inflation

Fund sectors sensitive to inflation and interest rates

Over the course of this week, we will publish Stifel Funds views on the sectors listed below in the event of a fall in inflation and interest rates. Here’s a summary to get us started:

• The Small and Mid-Cap sector is likely to be one of the fastest sectors to recover if inflation and interest rates fall given predominance of growth stocks and levered structures.
• The Private Equity Funds sector: there’s less pressure on levered structures and a re-rating of listed comparable companies used in multiple valuations could see the sector rally strongly.
• The Commodities & Mining sector: lower inflation may curb investor enthusiasm, with some derating, premium erosion and widening of discounts in such a scenario.
• Infrastructure: falling inflation is not a significant negative, given managers are modelling relatively low inflation in the next few years. Discount rates may fall.
• The Renewable Energy sector: a lower inflation and interest rate environment may result in lower discount rates. The funds are also modelling relatively low future inflation.
• e4eTechnology: a “Fed pivot” thanks to weaker inflation would likely propel the sector back into favour – especially earlier-stage, unprofitable growth companies.
• The Biotech sector: many unprofitable companies are valued on discounted future earnings, so lower rates are helpful. It is a non-debt industry, and is not impacted by leverage worries.
• Growth Capital: investors are more comfortable backing early-stage high-growth companies if inflation and interest rates have peaked, resulting in discounts narrowing.
• Royalties: if yields move down, investors would likely be more comfortable with the current discount rates used in valuations, and discounts could narrow as a result.
• Debt: as ‘risk-free’ yields have fallen post the recent spike, debt funds have recovered somewhat as their yields have become more attractive again relative to gilts. There is scope for further re-rating in a lower interest rate scenario.