Repositioning portfolios for high inflation
It’s hard to escape commentary on the eruption of inflation. Voters are telling pollsters that ‘cost of living pressures’ are front-of-mind in the context of the current federal election campaign.
Newspapers in Australia and overseas feature daily stories on the impact of soaring prices. After largely being a non-issue for several decades, inflation has come back with a vengeance.
It’s a good reminder that inflation is not just a measure of price rises in an economy. Rapidly rising inflation is harmful to consumers and households, and especially cruel to those already struggling.
It’s not my intention to drench this note with statistics, but I think it’s valuable to drop some facts and figures to convey the human dimensions of inflation, especially food price inflation.
Russia’s invasion of Ukraine has disrupted the supply of critical commodities, including wheat, corn, barley, and sunflower oil.(1) Over the past five years, the two countries together accounted for around 30% of the world’s wheat exports, 17% of corn, 32% of barley (a crucial animal feed), and 75% of sunflower seed oil, an important cooking oil.(2)
Not surprisingly, the United Nations food price index has hit a record high,(3) and food prices are now higher than during the 2008 global food crisis, which pushed an estimated 155 million people into extreme poverty.(4)
It’s horrifying to contemplate how many more people will go hungry in the time ahead.
Understandably, the term ‘transitory’, which often appeared in central banks’ commentary during much of last year when discussing inflation, has disappeared from their language.
Financial markets too are registering apprehension over the inflationary momentum with many bond, as well as share markets, registering negative returns over the recent three months to the end of March. The Australian share market’s positive return(5) was an outlier as the sharp run up in commodity prices benefited mining and energy companies, which make up such a large part of the local market index.
Persistently high inflation is challenging for bonds and shares
It’s rare for bond and share markets to weaken at the same time (‘positive correlation’ in investment industry speak), as they recently did. It usually requires something astonishing, like the fright stemming from the global outbreak of COVID in March 2020 that simultaneously downed defensive as well as growth assets.
To be clear, Russia’s February 24 invasion of Ukraine was a shock, especially as the long-term geopolitical ramifications may be far-reaching. But financial markets had been twitchy towards the end of last year owing to already galloping inflation and conjecture over central banks’ resolve to confronting it.
The phenomenon of shares and bonds moving in step may become more frequent if high inflation persists.
In environments where economic growth is the main driver of markets, shares and bonds, in combination, provide diversification.
When economic growth is strong, shares do well but bonds weaken on expectations of higher interest rates, and the opposite occurs during weak growth periods.
But when inflation is the driving force, the typical bonds-shares relationship weakens, and bonds are far less able to provide diversification against equities. In other words, sustained inflation makes it tough going for bonds as well as shares.
This recalls former US President Ronald Reagan’s depiction of inflation: “as violent as a mugger, as frightening as an armed robber and as deadly as a hitman”.(6)
The harm done to bonds and shares by high inflation is more than theoretical speculation. What happened during the terrible inflation of the 1970s is a reference point.
Traditional bonds struggled against the inflationary assault of that era. As for shares – companies did deliver earnings growth, but high inflation suppressed rewards to shareholders.
High inflation discounts the future value of cash flows measured in present terms, and so high inflation is bad for equity valuations.
We need to bear this in mind as we unpack contemporary financial markets. While there has been earnings growth across major share markets over the past decade, valuations have generally expanded by more than profits. This has been especially true for big name technology companies who have seen their price-earnings ratios(7) swell thanks to hitherto low inflation.
However, what low inflation giveth, high inflation can taketh away. The challenge ahead for investment professionals is to develop solutions to steer clients’ portfolios through this.
What worked in the low inflation era won’t work in the high inflation era.
Repositioning portfolios for high inflation
We were alert to the inflation threat before it erupted with our Investment Futures Framework – which underpins the management of our diversified retail funds(8) – being invaluable in this regard.
We had been factoring the possibility of higher inflation before the run up rise in prices across many economies last year because scenario 25 (“Global pandemic” in chart) made us think about the intersection of disrupted supply and rising pent-up demand creating the conditions for higher inflation.
Moreover, three explicitly inflationary scenarios (scenarios 3, 4, 7, and 22) are in our Investment Futures Framework, meaning that inflation is ever-present in the thinking and analysis behind the management of our diversified retail funds.
Explicitly inflationary scenarios (3, 4, 7, and 22) captured in the Investment Futures Framework
We upped our exposure to inflation-linked bonds, which were relatively cheap last year, as well as gold, another well-recognised inflation-hedge.
At the same time, we had been increasing exposure to resources companies while they too were attractively valued, even as their cashflows and margins swelled on the back of rising commodity prices. This basket of resources companies has broadened portfolio exposure to capture company earnings that increase with inflation.
While our diversified retail portfolios have had exposure to emerging markets and infrastructure through global shares exposures in the past, we added direct exposures to these sectors to broaden the portfolios’ drivers of growth during inflationary environments.
Innovating by using options
We also structured our basket of resources companies as a ‘participate and protect’ options strategy. By leaning on options, we have been able to access dividends, alongside downside protection.
While inflation-linked bonds are an obvious inflation-hedge, we believe our options-based basket of resources companies has been innovative as we have been able to capture the upside of resource companies’ shares without being exposed to all the ‘tail risks’ that would be the case if we just owned physical shares.
Options have also been key to our US equity positioning. From our perspective, the valuation gap between US equities and other share markets is a cautionary signal.
Additionally, given the risk to US valuations posed by rising interest rates, a margin of safety is necessary in any approach towards American shares.
Our solution, as with the basket of resources companies, has been to construct options-based structures. The options structures are flexible, and cost-effective, and include a currency component with some of the return contingent on the Australian dollar versus the US dollar being above a specified threshold.
Identifying non-traditional sources of inflation-protection
Traditional fixed income assets like government bonds are unattractive propositions, vulnerable to capital losses while high inflation persists, and as central banks embark on an interest rate hiking cycle. However, this doesn’t mean that investors should walk away from all forms of fixed income.
True diversification requires fixed income in the mix, albeit by looking in different places.
By being willing to look in different places, we have found insurance related investments (IRIs).
IRIs are investments in natural catastrophe risks. Investors take on the role of an insurer. They receive a yield – effectively an insurance premium – for taking the risk of a particular natural catastrophe causing losses above a certain level.
As the occurrence of natural catastrophes has no expected relationship with inflation (or with share market movements), IRIs are an attractive source of diversification.
As climate change related risks rise, so have IRI premiums. Still, because IRIs are non-traditional assets, many investors have been tiptoeing around them. That’s good for us as it’s meant that our portfolios are being well-rewarded for providing capital.
IRIs are just another example of our willingness to innovate if we can do so in a sensible, risk-controlled way for our clients and portfolios.
Inflation has been the theme of this commentary, and I will end with another thought on it.
Portfolios that have been engineered to prosper in the low inflation world since the 1990s now stand the risk of struggling as inflation has made an unwelcome return.
We have been rebalancing portfolios over the past year for a changing world, and the Investment Futures Framework has been indispensable.
There are no short-cuts, no magic formulas to delivering strong long-term returns. What matters is diversification, constantly refreshed and reimagined, discipline, and having the courage of your convictions to stick by your investment philosophy and process regardless of the fashions of the day.
Our portfolios combine our best thinking on asset allocation with a disciplined investment process, developed over 35 years, that optimises returns and reduces risk. Stay up to date with all my latest insights by clicking the follow button below.
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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...