She says the collapse of Credit Suisse and SVB bank will cause commercial banks to tighten their lending standards, a sharp reduction in lending by commercial banks has much the same impact on the real economy as if interest rates rose very sharply.
In this scenario, inflation falls due to a lack of supply of credit, and pushes economies into a sharp recession.
Investment implications
In terms of what this scenario means for investors, Stout says he is investing in defensive equities in areas such as emerging markets, where the growth picture is different, and in stocks that are exposed to “real assets”, such as commodity companies, and infrastructure assets such as the equity or airport operating companies.
Stout comments: “The vandalism that was quantitative easing proved an opium for asset prices and a smoke-screen for deeper economic distortions which it created and which would eventually manifest themselves. Now the inflation that printing money inevitably caused is the inflation that has ultimately killed it.
"Such naïve monetary policy is no longer sustainable under evolving economic circumstances simply because Government balance sheets are close to breaking point. What follows next could potentially become the most significant change to monetary policy since the early 1980’s.”
He added: “Should fundamentals be free to price risk going forward from here, the practice of reducing central bank balance sheets has broad implications for long-term equity multiples (lower), prevailing bond yields (higher) and optimal stock selection.
"Without dramatic improvements in productivity it’s reasonable to assume equity valuations based on profitability, cash flows and dividends would in general be reflective of lower economic growth, and would favour profits today rather that promises tomorrow.”
If investors do, as a result of fears around the outlook for inflation over the longer-term, prioritise earrings today, rather than the promise of future earnings, that would involve investors buying value, rather than growth stocks.
Mattias Born, chief investment officer at Berenberg Wealth and Asset Management says the era of low interest rates and low inflation helped growth stocks at the expense of value, but in a world of higher inflation, he would expect this to reverse.
But he also feels that as a consequence of higher interest rates, the more cyclical type of value equities will do badly, and so is sticking with defensive stocks in areas such as pharmaceuticals.
Duffose and her colleagues have responded to the risk of a sharper downturn by focusing on defensive areas of equity markets in areas such as consumer staples, but has increased the duration of the bond exposure in portfolios.
Longer-duration bonds tend to perform best when inflation is expected to be lower in future than now.
