Participate and protect: The key to riding out uncertainty

Jonathan Armitage

MLC Asset Management

The financial year has ended and it’s a fitting time to take stock of what’s transpired and to also look ahead. Double-digit gains across many share markets featured as investors priced in the economic recovery from COVID-19 and unemployment fell and confidence trekked back towards pre-pandemic levels in those markets.  But at the risk of sounding like a killjoy, I must caution that the size of this year’s returns may mean those over the next year or so could be a touch lower.

It’s difficult to imagine a repeat of the mix of factors that drove such strong recent performance. Central banks have pushed interest rates to record lows and created stunning levels of liquidity - a large slice of which has found its way into asset markets including the housing market. Governments too have gone all out to support economies and communities, but there must be growing doubts over their capacity to keep doing so.

An Institute of International Finance report found that the pandemic added around US$24 trillion to the global debt over the past year raising global debt to “at a record US$281 trillion and the worldwide debt-to-GDP ratio at over 355%". Government support programs accounted for about half of the rise.

Even at current remarkably low interest rates, which makes debt servicing tolerable, these are eye-popping numbers. An issue for investors must be what will happen if interest rates need to rise as the economic recovery gathers pace.

Inflation is on an upswing

Higher inflation, and with it the potential for higher interest rates, which would be negative for fixed income markets and complicating for shares, is arguably the dominant theme investment professionals are having to get our heads around.

As is often the case with financial markets, what happens in the United States has an outsize influence on the world and thus the following comments are US-focused.

Prices in the United States rose by 5% in May “compared with a year ago, the largest increase since the , continuing a steady climb in inflation”. A large share of May’s inflation upswing came from the car market as the “price of used cars and trucks continued to surge, rising 7.3% in May compared with April”. This “followed a 10% increase in April”. 

A range of factors brought about this state of affairs including the fact that “many rental car companies sold their fleets during the pandemic, leaving them short as Americans start travelling again”. There have also been supply-side issues with a semiconductor shortage making it harder for the auto industry to restock. Other ‘common items’ also recorded attention-grabbing monthly price rises with prices for household furnishings and services increasing “1.3% in May, its largest monthly increase since January 1976". 

Observers are also keeping a close eye on the rental market as rents consume a large slice of many Americans’ wallets. Rents didn’t move greatly during the most intensive part of the COVID crisis, “but they’re’ still up 1.8% from last year". As anyone who’s been a renter will know, rent rises tend to be sticky.

Sticky or temporary higher inflation

Policymakers appear to believe that the price rises will be transitory. That’s in part because the unusually low inflation readings of last year, on the back of shutdowns, will gradually drop out of future inflation calculations. 

The great debate among policymakers, economists, and the investment industry is whether higher inflation will be temporary, or whether it will persist.

Those who argue that higher inflation will persist emphasise that US macroeconomic “policy and, indeed, the very role of government in the economy, is undergoing its biggest shift in direction in 40 years”. 

America’s national debt rose “by almost US$7.8 trillion during” President Trump’s “time in the White House — approaching World War II levels, relative to the size of the economy”. 

The spending and debt momentum have continued under President Biden with the US$1.9 trillion stimulus package in March working its way through the economy. Moreover, a bipartisan group of Republican and Democratic senators recently agreed on a US$1.2 trillion infrastructure spending plan, “of which US$579 billion in new spending”. 

Turning an agreement into legislation that gains majority support in both houses of Congress and President Biden’s signature will require negotiating America’s hyper-partisan political terrain. Mr Biden is also receiving pushback from parts of his Democratic Party who want him to keep pursuing his more ambitious original plans. Still, given widespread recognition of the need to modernise America’s creaky infrastructure, another bout of sizeable spending appears to be on its way.

No wonder comparisons with the budgetary situation around WWII are being made.

Then, “US deficits remained between 15-30% of GDP for four years”. This year, US FY 2021, the US federal government “in its latest budget has estimated that the deficit will be 16.7% of GDP”. 

“While there are many meaningful differences between the pandemic and WWII”, the inflation-worry camp note that “annual inflation was 8.4%, 14.6% and 7.7% in 1946, 1947 and 1948 after the economy normalised and pent-up demand was released”.

There’s also been massive monetary stimulus as the US Federal Reserve’s (the Fed) “balance sheet has almost doubled during the pandemic to nearly US$8 trillion.” As economists would likely argue, ‘printing’ large amounts of money over a short period, which is what the Fed’s policies have effectively done, can create the conditions for potentially higher inflation.

Inflation doesn’t have to reach the alarming levels of the 1970s before it becomes damaging and distorting. It just has to be higher than the low levels of the past few decades for it to become troublesome. The worry is that inflation may get a grip before policymakers wake up to it.

Recalibration of US interest rate expectations

At its June meeting, the Fed left official interest rates unchanged but surprised with a more hawkish tone. Forecasts from the Fed for the 2021-2023 period included an unanticipated hint of two increases to official US interest rates by 2023, rather than hold them near zero. 

Financial markets have become so accustomed to central bank support that there must be some risk of a market fright should the Fed begin to embark on monetary normalisation, even if gently done.

Investors may recall the infamous May 2013 “taper tantrum” when the then-Fed chief Ben Bernanke triggered a jump in US 10-year bond yields (bond prices fell) when he testified before Congress of the Fed’s intention of winding back its asset purchase program.

‘Participate and protect’ strategies

All of this underscores why we have ‘participate and protect’ strategies in place. They can also be thought of as multi-eventuality strategies as they are prepared for multiple conditions and circumstances.

Our ‘participate and protect’ strategies enable our clients’ portfolios to benefit from rising risk asset markets. Equally, we have ‘derivatives’ in place so that our clients’ portfolios may be cushioned from the worst effects of market volatility.

Good long-term returns are gained not just by doing well in rising markets, but as importantly by defending clients’ portfolios during outbreaks of volatility.

Consistent with our emphasis on diversification, returns were gained from multiple sources including private equity, infrastructure, and alternative strategies, with different return patterns to listed shares.

Value managers in our listed shares portfolios also performed well, another example, we believe, of the merit of diversification, which includes giving our clients access to varied investment styles and approaches.

We’re confident that being faithful to principles of investment diversification exemplified by accessing returns from many sources will assist our clients’ portfolios in the years ahead.

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Jonathan Armitage
Chief Investment Officer
MLC Asset Management

As Chief Investment Officer, Jonathan leads the investment team and assumes overall responsibility for the investment outcomes of the MLC portfolios for both retail and institutional clients. In addition to the Multi-Asset portfolios, he is...

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