Don’t ask 'Will it rain?' Take an umbrella in case it does

Chad Padowitz

Talaria Asset Management

People often leave their house or car, look to the sky and ask themselves: "Is it going to rain?" But for us at Talaria it’s fundamentally the wrong question. The right one is: "Do I have an umbrella if it does?"

One of the great virtues of this question is that it is answerable in advance, and without forecasting.

When it comes to investing what can be known, or at least inferred, is the way a market is positioned ahead of an event.

For example, with the S&P 500 having outperformed MSCI World ex USA by more than 155% since the March 2009 post GFC low, and with the NASDAQ Composite having outperformed the S&P 500 by more than 70% over the same period, one can reasonably conclude that investors are heavily exposed to the broad US index - and that they are probably even more heavily exposed to Technology stocks.

Furthermore, with the S&P 500 and NASDAQ Composite trading on price earnings ratios of 22x and 34x today versus 13x and 22x a decade ago, the valuations at which investors maintain such exposures are high relative to history and in absolute terms.

So with that set up, what’s the impact of potential inflation? Is it transitory, cyclical or more long term? Everyone seems to have an opinion (forecasting again), and the bulk of the market is set up for it to be transitory - but that just shows that it too is the wrong question.

The right one is: Are you prepared if it’s not transitory?

Now if you don’t think it's worth worrying about, then consider some of the data out there to show that inflation may turn out to be more permanent. Perhaps the most striking is the below chart showing the intensity of coverage of corporate US labour shortages. If inflation is transitory, this should be falling.

  As of 17 October 2021

Now let’s look at a stock to really bring the inflation position point to light. Facebook (FB) currently has an earnings yield of 4.4%, yet the headline inflation rate is 5.4%. So if inflation increases or remains flat, you’re looking at a negative real return, which is theoretically at least a good way to lose money.

Obviously, Facebook’s earnings yield could turn out to be higher if earnings turn out to be better than forecast, but with the valuation at current levels, investors are placing a greater reliance on continued growth or multiple expansion, which comes with greater risk.

To expand that further the NASDAQ earnings yield is even less at 2.9%. Having persistent inflation above that level raises the risk of losing money for many investors.

So what to do? While future-proofing is impossible in investment, diversification provides a critical line of defence. Investors should consider prioritising:

  • Income versus capital growth
  • Active over passive management
  • Other parts of the world, away from the US and Australia
  • Non-tech versus tech sectors
  • Value-based strategies, over other investment styles.

To be forewarned is to be forearmed and so while we are not in the business of forecasting, we are in the business of being as prepared as possible. 

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The information in this article is general information only and is not based on the objectives, financial situation or needs of any particular investor. In deciding whether to acquire, hold or dispose of the product you should obtain a copy of the current Product Disclosure Statement (PDS) for the Fund and consider whether the product is appropriate for you. Wholesale Units in the Talaria Global Equity Fund (the Fund) are issued by Australian Unity Funds Management Limited ABN 60 071 497 115, AFS Licence No. 234454. Talaria Asset Management Pty Ltd ABN 67 130 534 342, AFS Licence No, 333732 is the investment manager and distributor of the Fund. References to “we” means Talaria Asset Management Pty Ltd, the investment manager. A copy of the PDS is available at australianunity.com.au/wealth or by calling Australian Unity Wealth Investor Services team on 13 29 39. Investment decisions should not be made upon the basis of the Fund’s past performance or distribution rate, or any ratings given by a rating agency, since each of these can vary. In addition, ratings need to be understood in the context of the full report issued by the rating agency itself. The information provided in the document is current at the time of publication.

Co-Chief Investment Officer
Talaria Asset Management

Chad is the Co-Chief Investment Officer and co-founder of Talaria Asset Management. He has more than 20 years’ experience in the financial services industry in the UK, South Africa and Australia. Talaria's investment strategy seeks to increase the...

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