Are you being seduced by the beautiful bull market?

Equity markets and risk assets are in the midst of a stunning bull run. The local index has enjoyed 11 consecutive monthly gains, a winning streak not seen since 1943.

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Just enough inflation to be a problem

The market has become obsessed with the topic of inflation, and rightly so, according to Charlie Jamieson, Chief Investment Officer at Jamieson Coote Bonds.

But there’s one key aspect that isn’t being debated: that the link between inflation and central bank policy is direct, and from the current emergency settings, that the hint of higher rates will be problematic.

Instead, the debate is focused on whether the inflationary impulse will be sustained or if, as has been the case since the Global Financial Crisis, hitting inflation targets remains “Mission: Impossible” for central bankers.

“It can be just problematic enough to make central bankers do something about it. And that’s where it becomes interesting given we still have these very accommodative settings,” says Jamieson.

He fully expects periods of higher inflation associated with supply disruptions, and this is likely to be a source of volatility for investment markets.

Are we likely to see materially higher rates?

Not in the near to medium term, says Jamieson. He can’t see markets “living” under materially higher rates and is yet to see a policy framework showing how this could occur.

“I don’t believe that we’re going to 3%, 4% or 5% interest rate settings anytime soon because the debt loads are simply too high.”

Normalisation can happen, but the new high for a rate-cycles will be extremely low, says Jamieson.

Crestone’s Scott Haslem shares this short-term outlook on rates. He expects inflation will moderate more than many expect as we move into 2022. He is less confident in the longer-term view and holds concerns that too much money will be chasing too few goods and services. Ultra-high inflation is not on the cards, but that doesn’t mean it can’t cause a few headaches.

“I could see a scenario where inflation settles in at 2.5% to 3% rather than 1.5% to 2%. I think that would have a material impact on markets, portfolio design and how you would think about inflation.”

A bet against inflation is betting against every government and central bank in the world, says Haslem. “Philip Lowe is sitting there subject to review from the OECD because they haven’t hit their inflation target,” he says.

Independent investment consultant Giselle Roux says that the inflation debate transcends economics. Goods and services are inflating but incomes are not increasing at the same rate. Healthcare is one example, and housing is another, where price-to-income ratios have gone ballistic,” Roux says.

“I think there is more to the inflation argument than just the rates. The actual impact on investors, households and behaviour may well be quite different to what we’ve experienced in the past.”

Can I just have my 5% - 6%? 

Haslem quipped that the first three years of his job were spent talking down return expectations of clients: “A lot of investors struggle to align their true risk profile with their return expectations of 10% with no volatility.”

But is it reasonable to achieve a return of 5% - 6%, which was the return target most frequently cited by Livewire readers in a recent survey? Haslem believes so. His only caveat is that the return objective needs to be set over a multi-year timeframe. There will be volatility in the returns from year to year.

Roux agrees, but says the traditional 60:40 asset allocation is unlikely to deliver those returns.

“I think people need to be prepared to consider other non-traditional investment options that give them greater diversity,” she says.

Investors should also be wary of skewing their portfolios too heavily towards income-generating assets. And Roux says it makes complete sense to sell down a portion of growth assets, such as equities, to fund living needs, especially after a strong rally.

Alternatives: The pros and cons

These days, a conversation about portfolio construction is difficult without stirring up a vigorous debate about Alternatives. Perhaps we’ve become obsessed with the debate ever since the former Federal Treasurer Peter Costello told us it was suitable for the Future Fund, but not for the average folk of Australia.

In the seven years since starting Livewire, I’ve seen investors become more comfortable with global shares as more articles and educational content on the theme has been published. I expect Alternatives will head in a similar direction, albeit to a lesser extent.

For Haslem, the pros of Alternatives are clear. They have different risk and return characteristics to portfolio staples and can boost returns and add diversification. He has a strong preference for unlisted structures and says manager dispersion is exceptionally high.

“The difference between best and worst in large-cap equities might not be that much. In Alternatives, the difference between the best and worst can be 10%,” he says.

The main drawbacks of alternatives are:

1. The potential complexity of the underlying assets and investment strategies, and
2. The requirement to sacrifice some liquidity.

Roux also sees a role for Alternatives but says investors need to tread carefully and go in with their eyes wide open.

“The one thing about alternatives is that because they are not priced in liquid markets, you are not going to see volatility, but you need to understand that there is significant risk in many of these portfolios,” she says.

Unlike stocks with broker coverage and regular news flow, many of the investments in asset classes like Private Credit and Private Equity are complex, and the risks are not always apparent to investors. Roux says she spends a considerable amount of time trying to understand some of these products, and even she struggles to get her head around some of the offerings.

“Higher returns inevitably means that there is higher risk being taken in many of these portfolios.”

A few tips to keep your portfolio match fit

I asked each of my guests for a specific risk, either from the big picture or at the portfolio level, that might help Livewire’s audience of investors think about the path ahead.

Consistent with our recent survey, Haslem is mindful of geopolitical risks and the potential to impact risk appetite in the world. He says investors should be aware of this when thinking about their overall portfolios. More specifically, he says investors rolling out of term deposits are now staring at near-zero returns on cash. He believes it would be a mistake to roll this into riskier assets in search of higher returns and changing the risk profile of your portfolio.

Roux says it’s time to think hard about the outlook for the Australian economy. We’ve already seen the mining sector roll-off, immigration will be subdued, and property prices are sky-high.

“We can see the Australian dollar starting to show that risk aversion towards Australia already,” she says.

Roux believes investors should not be overly exposed to the domestic economy. In her view, now is a good time to think about unhedged offshore exposure to buffer against any weakness.

Jamieson is also casting his eyes towards what lies ahead in 2022. He is mindful of the looming US fiscal cliff representing the largest fiscal contraction since World War 2. He says political dysfunction is already bubbling away, and the private sector has an enormous amount of slack to absorb if the US growth train is to stay on track. 

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