Which investment trusts will benefit from a sharp drop in inflation?

Real estate, private equity and technology are among the trust sectors that could benefit most, writes Faith Glasgow.

Who’d be a forecaster in 2023? Prospects for inflation are improving as central banks tighten the interest rate screws on Western economies; but big questions remain, in the UK at least, as to how fast and how smooth the decline in rising prices will be.

A recent note from broker Stifel argues that “we have likely seen the peak in US and UK consumer price inflation”, and outlines the case for inflation falling more quickly than many investors expect this year.

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Stifel believes several factors could contribute to rapid disinflation. These include declining power prices, reduced money supply as a result of central bank interest rate rises, the working through of higher inflation by April (so that year-on-year price increases are more modest because they’re measured from a higher starting base level), sluggish economic growth, and the weaker US dollar, which has helped reduce commodity import prices.

However, other commentators are less confident of the direction of inflationary travel. Peter Walls, manager of the Unicorn Mastertrust fund, says: “My expectation is that we will see a dramatic fall initially, but thereafter it’s anyone’s guess.”

Andrew McHattie, publisher of the Investment Trust Newsletter, is similarly circumspect. “Inflation has started to fall away from its highest levels in most major Western economies, and in many cases faster than expected; it could happen in the UK too, but the picture here is not clear,” he says. 

McHattie points to current widespread labour disputes and the real risk of a wage/price spiral taking hold, which would exacerbate inflationary pressures. Prices could be further affected if the post-Brexit UK economy runs up against new supply constraints.

Nonetheless, there is potential for inflation to drop sharply in coming months – and if it does, there could be a positive response from the investment trust sectors that have been hardest hit by inflation concerns and resultant base rate rises.

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Smaller and mid-cap companies are obvious candidates. Both had a torrid year to end October, when the outlook started to pick up: the UK mid-cap sector suffered a net asset value (NAV) total return decline of -28%, while UK smaller companies lost -29%.

“We would expect the small and mid-cap funds to be one of the fastest areas to recover if the environment changes to falling inflation and lower interest rates,” says Stifel’s note. “We have seen some clear signs of this in the last three months: the FTSE 250 index has risen +14.4% and the FTSE Small Cap (ex investment trusts) +15.9%, with the average discount narrowing to 9% at 3 February 2023.”

These funds are responsive to improvement in the outlook for interest rates partly because they tend to be leveraged (borrowing costs will come down) and partly because of the focus on high-growth companies, which are relatively sensitive to discount rates.

According to McHattie, other sectors that could rebound powerfully include private equity, growth capital and technology, as well as other areas that are highly discount-rate sensitive, such as song royalties, real assets and property. “It’s a fairly long list, as the share price damage has been widespread,” he observes.

He suggests that investors could do well by “discount hunting” – looking for the investment trusts that have been most heavily sold off against their asset values. Growth trusts such as Seraphim Space (LSE:SSIT) (55.7% discount), Augmentum Fintech (LSE:AUGM) (32.3% discount) and Menhaden Resource Efficiency (LSE:MHN) (31.5% discount) “have plenty of scope to bounce”.

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Indeed, he adds: “Whisper it quietly, but a swing in sentiment could also lift the sector’s largest trust, Scottish Mortgage (LSE:SMT) (14.8% discount), out of the doldrums.” 

However, Walls argues that growth capital may continue to be blighted even if inflation returns to its previous low levels, due to the fact that base levels of prices have been elevated.

“I do not believe that the high-growth expectation/low current revenue/sales unicorns which suffered big price falls in 2022 are likely to recover that quickly,” he comments.

He suggests that trusts looking for “growth at a reasonable price” (GARP) are likely to be in a stronger position.

“With the benefit of hindsight, GARP portfolios were very unreasonably valued pre-Ukraine. They have been severely derated, yet the majority of businesses will continue to grow, albeit at a more sedate rate in the short term.” Again, these are likely to be smaller companies-focused; Walls picks out BlackRock Throgmorton (LSE:THRG) and Henderson Smaller Companies (LSE:HSL).

Of course, there will be losers as well as winners if inflation does come down swiftly. Sectors that have done well from inflation linkage as prices have risen include infrastructure and renewable energy. Stifel says commodities also tend to benefit from higher levels of inflation, and so may see widening share price discounts to NAV if it falls.