Some inflationary scenarios, and what they mean for portfolio construction
Given inflation is the most prominent theme in global investment markets, I wanted to provide some thought and insight into what the various outcomes of inflation could mean for markets, and how this could possibly affect the composition of portfolios (including where could possibly be attractive under certain environments).
At Innova, we run a lot of scenario analysis to test what could happen in various asset classes based on future outcomes - it sounds simple, but can be somewhat complex. Whilst this isn't an exhaustive list and we certainly don't predict any of these as a certainty, we do stress-test as part of our process as we believe it's a sensible exercise to go through when building a multi-asset portfolio that is truly diversified.
Here are some of our thoughts:
Scenario 1 - Rising inflation with positive economic growth:
- We see this as a more likely scenario, given we are seeing stronger economic activity through stronger employment numbers, however still with plenty of productive capacity left as we aren't near full employment. Therefore, businesses should see higher margins and growing demand, meaning more sales.
- This is being shown as PMI (Purchasing Manager's Index) numbers are increasing, as is global demand for raw materials.
- The vaccine rollout will be an important driving factor to avoid future lockdowns and an economic slowdown. This will also help to stop deflationary pressures.
- In this situation, we believe the FED will allow the long end of the yield curve to rise within a certain band if the underlying economic activity warrants it, but not necessarily raise interest rates. The RBA would be likely to do the same thing.
- This would be the most positive scenario for cyclical sectors including financials, industrials, materials and energy which will likely do well. Government bonds and long-duration equities (including growthier-style equities, or 'bond proxies') will likely underperform value equities.
Scenario 2 - Rising inflation with stalling economic growth:
- We see this as a tail risk (i.e. low probability) in the next 18 months given the positive signs of normalization across most major economic indicators, including employment and global productivity, as well as the excess capacity still to be taken on in employment numbers.
- This would be problematic as the correlation between equities and credit, as well as treasury bonds, would likely become positive and therefore all sell off in conjunction.
- The outlook in this scenario for equities is less clear today than in the past - usually we would say owning quality equities would be a suitable strategy although today many quality companies are richly-priced. (This was the case in the 70's with the 'Nifty Fifty' stocks of the US, including Procter & Gamble & McDonalds, who's prices were driven so high by perceived stability that they underperformed as a group significantly for a long period when markets turned).
- Tilting towards value equities that don't have as much sensitivity to interest rates or bond rates could be advantageous in this scenario - whilst value stocks typically don't do well in recessionary environments, a downturn in markets accompanied with inflation could be an exception.
- Gold will also tend to do well in this environment if inflation is rising faster than nominal bond rates, and the interest rates remain low.
Scenario 3 - Positive economic growth but with inflation subdued:
- Despite all the talk of impending higher inflation, it is not guaranteed as economies are still yet to reach full employment. In the US, the unemployment benefits being paid by the Biden administration are still paying some workers more than what they were earning prior to work being ceased in September - these people will have to return to work at some stage, potentially keeping wage growth down.
- Provided inflation remains at the lower end of where we are currently, we believe lower-priced equities (including a value bias, as well as looking at regional equities including emerging markets) will offer the best risk/reward ratio.
- In the fixed income space, we believe credit instruments paying a moderate yield (including investment grade loans) might also offer a good risk/return profile.
but What if there is a valuation-driven downturn (such as the Tech-Wreck) that happens again?
- This is a difficult scenario to model for, as there is very rarely an obvious trigger.
- Government bonds could do well here, as investors seek protection in almost any form when a bubble bursts. Gold could experience an initial sell-off as investors seek liquidity, but would likely then start being stockpiled as a protective asset as it has in the past (including in last year's pandemic).
- Historically, high-quality equities do well in this scenario, however if they're overpriced there's no guarantee - Microsoft was a fantastic company and highly profitable in 1999, but it took 15 years before it got back to it's previous high after the tech bubble burst.
- So again, we always prefer sectors/biases/regions that aren't richly priced but still have quality elements to them (including solid businesses in Japan and the Emerging Market regions).
We hope the above shows that different types of assets will do better in different scenarios. As a multi-asset manager, Innova is always seeking to diversify appropriately and weight portfolios to those assets that will do better in the more likely-scenarios.
It's hard to predict the future, and uncertainty at the moment is at a very high-level, so the ability to keep portfolios nimble and progressively shift toward more accommodating asset and sub-asset classes, will be the key to navigating the next several years.
Dan is the Managing Director & Co-CIO of Innova Asset Management, a boutique asset consultant and investment manager specialising in multi-asset, diversified investing with a particular focus on managing risk to create robust portfolios for clients.