The Reflation Trade, Solvency & Backing Britain

28 February 2021

A recent headline in the Sunday Times from the UK’s Chief Medical Officer, Chris Witty, stated “We are far from out of the woods – please do not act as if we are”. He was of course referring to the UK public’s attitude towards the virus and our adherence to the latest lockdown restrictions. However, his warnings also apply to the recent behaviour of financial markets.  

WHAT INFLATION? - We hardly need reminding that 2020 was a strange year. But one thing markets weren’t overtly concerned about was the risk of inflation. Demand for many goods and services were decimated and the productive capacity of many sectors were put into enforced hibernation. The UK RPI was at 1.8% a year ago and steadily fell to a low of 0.6% in November. Clearly nothing to see here.  

IT’S EVERYWHERE - Fast forward to 2021, the financial world is in the grip of The Big Reflation Trade with articles everywhere cautioning about the risk of inflation. Bond yields are rising, equities are rising, the dollar is weakening and there seems to an outbreak of bubble mania: SPACS, IPOs, Cryptocurrencies, Commodities and Tesla shares are all held up as clear evidence of inflation, potentially of ruinous proportions. What was a fringe interest in financial markets only a few months ago has become the consensus view. Inflation is now looking like a crowded trade and one that could become over populated. The triggers for the change in view are a combination of: 

  1. The prevailing view of a vaccine moving from, IF we get a vaccine, to WHEN they (multiple vaccines) might become effective in delivering herd immunity. 
  2. Increased concern about the exceptional growth in public debt levels and growth in measures of narrow money supply, compounded recently by the cost of further lockdowns.
  3. The move to a Democratic political agenda in the US with consequently larger and more coordinated fiscal and monetary measures to alleviate the pandemic and its economic impact.   

WAKE UP CALL – The main investment theme until last November was COVID-19, the accelerant. We had known for a while that big tech, big data and software would eat the world, only it was now happening much more quickly. Meanwhile the old economy sectors were in hibernation often only able to survive with state intervention. Then everything changed and the Pfizer BioNtech vaccine trial results were announced. The pivot was almost instant. Everything was safe and the world would return to normal. In stock market terms everything that was last, now shall be first and vice versa. It seemed clear we were returning to our familiar “normal” and the Biden victory just seemed to neatly underline this view. 

CHOPPY WATERS - Three months on and things have changed again. The build-up of inflationary expectations is growing rapidly at a time when most countries are about to go into a double dip recession as the (final) waves of COVD-19 (in its various mutated forms) are beating a fierce backlash across most areas of the Europe, N America and even previous less affected outliers, like Japan. So far this has led markets to strengthen their faith in extra government financial assistance programmes, which they now see as inevitable. While this might be right and ultimately inflationary, there is also a critical period ahead of heightened uncertainty and conflicting macro messages. It might be like rowing a boat into choppy waters impacted by conflicting currents and tides. The prospects for eddies and upsets, periods of discontinuation, are increasing in financial markets. 

BACK TO THE FUTURE – Yet, over the course of the next decade most governments need to undertake some extraordinary policy manoeuvres to reduce their levels of public debt and a controlled level of inflation is becoming an overt policy goal. The most analogous decade to the 2020s is the 1970s. However, what this doesn’t mean is that what we are seeing now (or think we are seeing) is necessarily the early signs of inflation. 

WHAT DID COVID DO FOR US? - Rather than the early warning signs of overheating, what we are currently experiencing is more to do with disrupted and changing supply chains and a move to more resilient business models and financing structures. A less globalised world, or at least a world less reliant on China for its manufactured goods, might be safer, but it would almost certainly be more expensive. Companies and individuals won’t forget this period in a hurry, and while there is every likelihood of a quick rebound certain areas (such as retail spending, leisure travel and events), the economy will take time to heal. Companies and countries and their citizens are likely retain larger financial floats, in the form of higher inventory levels, stronger balance sheets and a greater allocation of wealth to long term savings. We don’t yet know what damage the COVID period will have inflicted on our productive capacity and general solvency, but we will bear scars, both real and behavioural.

STAND UP FOR SOLVENCY - Jeremy Grantham among other market timing gurus think they see trouble ahead and the next trigger point might well be herd immunity. This is the moment when the global economies, and their combatants will have to be re-assessed for their ability to walk unaided. Many have been pumped with the drip-feed of liquidity, they now must be assessed for their ability to stand unaided. The critical test will not be liquidity, but solvency. This could dampen some animal spirits in some of the more speculative markets.

OVER HERE OR OVER THERE? - If the Buffet measure of a country’s ratio of equity market cap to GDP is any guide, then the UK and Japan offer much better prospects for equity returns than the US. A move into Japanese equities has been one of very few net new investments made by Berkshire Hathaway in the last 12 months, after selling sizable amounts of US banks and airlines. While the US is at is all time high on this measure and some 50% above its previous 2007 peak, the UK is at only 50% of its historic high and 30% below the level seen in 2007. On this measure UK equities offer an attractive margin of safety.  In the last five years Brexit concerns have choked back corporate investment and kept a lid on corporate valuations. While the US has seen their Big Tech and SaaS heavy NASDAQ go to new highs, it has drawn out IPOs from private hands that have popped, growing the aggregate capitalisation of its publicly traded equities. By contrast the UK has been largely a spectator and has lost publicly traded companies to overseas and take private acquirers. 

BACKING BRITAIN - The UK now looks like a an attractive place to invest. With a Brexit trade deal done and cut and paste deals with more countries following on, the UK can now be reassessed as a place to do business. It might not be optimal, but it is more certain. The UK has an attractive collection of corporate assets, many leaders on a world stage and typically trading significantly below valuations of their North American peers. We have already seen a notable increase in UK M&A activity in recent months, this will at least continue, if not accelerate. Meanwhile there is also a growing pipeline of privately owned UK businesses looking to join the public markets. City am has identified, Darktrace, Deliveroo and Transferwise as the leading UK IPO contenders with dozens of others rumoured to be looking. The UK has an enviable list of fintech and tech enabled companies in private ownership that could fuel a decent run of equity issuance. 

MICROCHIPS TO MOLECULES – The UK also has an opportunity in 2021 to distinguish itself among other economies and capital markets in a more strategic sense. As Matt Ridley points out in the Sunday Telegraph, while the UK often leads the world in self-criticism, none other than The New York Times has pointed out that the UK also leads the world in COVID-19 DNA sequencing. The Oxford vaccine success and the efficiency with which the UK has approved vaccines to date are all indicative of the UK’s competitive advantage in bioscience. As the optimistic Mr Ridley says if the next 50 years is going to be dominated by innovation in biotech, as the past 50 were dominated by IT, then Britain is well placed.   


Dowgate’s investment process is all about buying and holding great businesses for the long term as a cornerstone to managing our clients’ wealth. However, we are not immune from the opportunities that gyrations of the financial markets present to seek relative value, without losing sight of our quality threshold. 

In a typical week, we meet up to 20 company management teams in an ongoing search to find valuable opportunities. Our first objective in these meetings is to establish some basic understanding of the companies and their prospects. We want to understand the sense of purpose and drive from the leadership. Specifically, the importance they focus on financial and other operational metrics, including their capital allocation process. Our goal is to assess if these are the people and organisations sufficiently differentiated and trustworthy to which we are prepared to allocate our clients’ capital. There is a multitude of factors that we consider before taking this decision. Some of the important ones are experience, financial track record, access to technology (product or process know-how), and shareholder focus.  

Part of our process is to understand the main drivers of innovative growth that impact all companies. These include the adoption of networked knowledge, deep learning AI, green energy, robotics and autonomous transport, DNA sequencing and frictionless finance. All these factors are, to differing degrees, impacting our universe of investable companies. This aspect of our process is increasingly important as technological change accelerates and its adoption becomes more widely implemented. 

However, we are also alert to the value opportunities the market can present. UK small and medium-size companies include many world-class capabilities that drive and benefit from identifiable secular trends. Currently, UK companies are lowly valued, particularly compared to their US peers. It is among these companies that we see the most attractive opportunities for us to add value as part of ongoing process of managing our clients’ wealth.   

Written by Jeremy McKeown