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Overview

The global economy is currently facing a unique inflationary environment in which pockets of inflation are developing in certain industries and geographies, yet excess capacity in other parts of the world is resulting in a more subdued inflationary environment overall. As these fluid inflationary conditions unfold, Manning & Napier is seeking to capitalize on opportunities by investing in the principal economic concepts that high returns attract capital, and that when demand outpaces supply, prices rise. With an active, equity-based investment approach, we are focused on well-positioned, quality companies that can excel given the nature of inflation in the current environment. Such an approach emphasizes economic fundamentals instead of investment sentiment and also allows for the flexibility to adapt to changing conditions over time.

The Current Inflationary Environment

As global economies continue to distance themselves from recession lows, expectations for inflation are becoming a key focal point for investors. In recent years, signs of inflation have grown more prevalent with news stories frequently highlighting rising prices or the potential for inflation to ignite down the road. At the start of 2011, for instance, commodity prices in particular were experiencing upward pressure and many headline inflationary measures were increasing at an accelerating pace. However, broad global economic weakness later in the year caused inflationary pressures to recede somewhat. In spite of this, commodity prices, oil in particular, were on the rise again early in 2012 suggesting that inflationary vigilance will remain important in the months, quarters, and years ahead.

Yet despite such a heightened focus on inflation, the nature of the current inflationary environment is somewhat complex. In fact, most of the developed world is still working through the significant amount of slack leftover from the last recession, which does not reflect conditions that typically result in inflation. Excluding more volatile food and energy prices, core measures of inflation are rising in many developed economies including the U.S., but the level of inflation is generally considered acceptable by central bankers and policymakers. While the entire global economy may not be in the midst of a widespread inflationary spiral, this does not mean inflation is nonexistent. Rather, the basic economic principal that money flows toward areas of high return remains in play today. This dynamic is most visible in emerging markets as these economies are enjoying relatively strong long-term growth prospects. However, emerging markets were not immune to the broad deceleration in global economic growth experienced in late 2011, and there too inflationary pressures have subsided in recent months.

Over the long-term, rapid growth in emerging economies could contribute to inflationary forces, but relatively loose monetary policies in the developed world may continue to play a role as well. In an effort to provide support during the credit crisis and its aftermath, many central banks enacted accommodative monetary policy, including injections of liquidity or versions of quantitative easing. Some central banks, perhaps most notably the Federal Reserve, are still in the process of monetary easing. More recently, central banks in emerging markets have joined the cause, easing monetary controls in an effort to support growth.

As a result, global money supply has increased and excess liquidity has been created. Central bankers in developed nations believe they have the tools to remove this liquidity from the system when needed, but the ultimate long-term impact remains difficult to predict. Indeed, excess liquidity from the developed world may find its way into emerging markets, potentially reigniting inflationary pressures down the road (Chart 1). Similarly, food and energy prices could face upward pressure (Chart 2) in response to a variety of factors, including specific industry dynamics, emerging market demand, and excess liquidity from the developed world pursuing higher returns.

While specific sources of inflation are developing in the current environment, conditions do not indicate that broad-based global inflation is likely in the near-term. Such distinct inflationary pressures differ from traditional ideas of inflation, such as the U.S. wage-price spiral in the 1970s. However, inflationary forces around the world are certainly real and worth addressing. In this dynamic and evolving environment, Manning & Napier believes the best investment approach is to focus on the fundamental idea that high returns attract capital and investment opportunities, but ultimately higher prices beget lower prices as rising capital flows eventually lead to increased supply overwhelming demand.

Opportunities in Inflation

As the changing nature of supply and demand relationships creates uncertainty regarding the future outlook for global inflation, Manning & Napier believes an active investment approach that can adapt to evolving inflationary conditions is important. By evaluating broad global themes and specific industry trends, we are looking for opportunities in the sources and beneficiaries of inflationary pressures, which can shift over time. More specifically, in our inflation-focused investment approach, Manning & Napier is seeking to identify conditions that will create upwards pricing pressure, industries that may benefit from those higher prices, and finally specific companies with strong fundamentals and pricing power that can prosper from that rising inflation. Through active stock selection and a close monitoring of supply and demand trends, this global strategy seeks to add value in a variety of inflationary environments. In other words, if the nature of inflation were to change in the coming years, this investment strategy would have the ability to adapt to evolving conditions and seek opportunities in different types of environments.

Manning & Napier’s inflation-focused strategy is a blend of top-down thematic investing and bottom-up company selection. Analyzing trends and investment opportunities across countries, industries, and market caps, we develop certain overarching themes that help shape our understanding of the inflationary environment. As supply tightens relative to demand for a commodity, good, or service, we seek to invest in the producers based on the view that money moves toward areas of higher returns caused by demand overwhelming supply. Likewise, opportunities for pricing power can arise in particular industries that have a tight relationship between supply and demand. As such, an example of a potential inflationary theme could be “AgFlation,” which has several long-term drivers that may increase prices over time. On the supply side, there can be short-term issues related to weather or harvests, as well as longer-term structural issues related to a limited amount of available arable land. Meanwhile, demand for grains and other agricultural products continues to rise as the growing middle class in the emerging markets consumes more food and develops more grain-intensive diets, such as eating more meat. Other potential inflationary examples include “FuelFlation” and metals and mining. In both areas, demand appears to be increasing because of emerging market growth, yet supply is constrained due to the difficulty and capital intensity of bringing on new capacity. Oil has become increasingly expensive to extract from the ground, and the oil industry cut capital spending drastically during the recession, which means the pipeline for new supply may be smaller in future years. As for metals and mining, there has been a historic period of underinvestment in exploration, and ore grades continue to decline. In all three of these examples, tightness of supply relative to demand could lead to higher prices.

Potential Inflation Themes

*May not reflect current holdings.

With this big-picture framework in place, Manning & Napier then analyzes those industries that may benefit from inflationary trends. A close review of industry characteristics helps show what types of companies may have favorable fundamentals. If an industry is cyclical, it will likely have different stages that have distinct investment implications. For instance, we look to invest in the producers when industry-wide returns are low, demand is declining, and supply is being removed from the market. When conditions and returns start to improve, we seek to own the suppliers that can benefit from the industry’s increased incentive to invest. Finally, when prices approach a peak and create demand destruction, we focus on the consumers that may be getting squeezed by higher prices. To put that in the context of the energy industry, the producers would be the exploration and production companies that own hard assets; the suppliers would be the oil services companies that benefit from spending to increase capacity; and the consumers would be the airlines and transportation companies that may be better positioned when prices eventually fall. With the guidance of our broader inflationary themes and our specific industry assessments, we then use our disciplined stock selection strategies to uncover companies that present attractive investment opportunities on a standalone basis and in the case of inflationary conditions.

Why Equities?

An equity-based inflation strategy is not the common way investors hedge against inflation, because inflation is usually viewed as a broad-based rise in prices. However, Manning & Napier believes this active approach offers many advantages over more traditional inflation-hedged investments, such as Treasury Inflation-Protected Securities (TIPS) and commodities. Perhaps most importantly, by investing in a flexible strategy that can adapt to market changes at the industry level, one does not have to take the risk of positioning exclusively for low inflation or high inflation. Furthermore, with such an active approach, one does not have to predict exactly when a transition from lower inflation to higher inflation may occur. Rather, through our thematic overviews and specific stock selections, we actively manage inflation risk for investors based upon the nature of inflation in the current environment. The current themes and positioning of our inflation-focused strategy reflect how we view inflation in the world today – we are targeting companies that can benefit from pockets of inflation. However, this environment may evolve over time, and this investment approach could adapt to those changing inflationary conditions, including a broad-based inflationary environment if that were to occur. In such an environment, the stocks we are targeting may change. For instance, we may put an even greater emphasis on companies with a powerful competitive advantage that can benefit from specific bottlenecks of supply. Ultimately, though, the investment strategy would stay the same because of its innate ability to adapt to various inflationary environments.

In addition to greater flexibility, an active, equity-based inflation strategy also focuses more on fundamentals than sentiment. In contrast, many traditional inflation strategies, such as TIPS or commodities, can be heavily impacted by expectations and investment sentiment. When investing in commodities, future expectations can be just as important if not more important than supply and demand dynamics. For instance, speculation and other factors can cause oil prices to move higher than the level of marginal demand implies. In this sense, commodities can be a zero sum game; if prices don’t go up, you lose money. On the other hand, the company that produces the commodity can benefit from economics as long as the cost of the commodity is above the marginal cost of production. The company has the ability to continue earning money even if the commodity does not go straight up. That means that as an investor in the company, you do not have to pick the commodity price or guess what others expect that price to be. As for TIPS, this investment option is generally appropriate for periods of widespread inflation, such as an environment of higher wages. With such high unemployment, Manning & Napier does not currently see those conditions in place. Furthermore, by investing in TIPS, one has to predict that inflation is accelerating and that inflation will be higher than others expect. Instead of trying to guess sentiment and expectations, Manning & Napier prefers to invest in the concept that money is attracted to areas of high return, which means we want to focus on companies operating in those particular areas. Ultimately, we believe companies in those areas of high return can benefit even if broad inflation does not occur.

Conclusion

With an active, equity-based investment approach, Manning & Napier is looking for the sources of inflation and then for the companies positioned to benefit from those pricing pressures. Such a flexible strategy does not require a precise prediction of the level of inflation in the future. Similarly, Manning & Napier is not “betting” on whether broad inflation will be higher or lower than others expect, which is largely dependent on sentiment. Rather, we are analyzing the fundamentals across geographic regions and global industries to seek out those strong companies that can also excel in an inflationary environment. As inflationary conditions continue to unfold, Manning & Napier believes this fundamentals-based approach will remain attractive in various inflationary environments.

Unless otherwise noted, all figures are based in USD.

Manning & Napier Advisors, LLC (Manning & Napier) is governed under the regulations of the U.S. Securities and Exchange Commission (SEC).

Analysis: Manning & Napier.

Sources: The Wall Street Journal, FactSet, MSNBC, Foreign Policy, BBVA Bancomer.

All investments contain risk and may lose value. This material contains the opinions of Manning & Napier Advisors, LLC, which are subject to change based on evolving market and economic conditions. This material has been distributed for informational purposes only. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed.