Will the cost-of-living inflation crash the asset price party?
Markets have bounced back strongly from COVID-induced lows which, combined with the significant deployment of cash into attractively priced shares, have produced healthy returns of 37.3% and 9.8%pa for the fund over the prior 12 months and almost 14 years since inception respectively.
We remain cognisant of the “extremely low cost of money” setting being applied by Central Banks globally and the inflationary impact it is having on long-duration asset valuations. In addition, the paucity of yield on offer from traditional bonds/term deposits continues to push investors up the risk curve. Our clients continue to pepper us with requests for the elusive 4% plus AAA investment option as a substitute for the 50 basis point term deposits currently on offer.
The potential consequences of these loose monetary settings combined with widespread stimulus require careful consideration. More money chasing the same amount of, or less, goods (supply chain constraints) implies higher prices and, more importantly, ever-increasing expectations of higher prices. Governments are caught between a rock and a hard place – the bond issuance (funding requirement) upgrade cycle is only getting started as any fiscal discipline continues to be overwhelmed by the pandemic-induced actions. Higher CPI readings would not help their funding costs or their indexed welfare payments.
Our portfolio has been positioned for this environment. We remain focused on “hard assets” underpinned by pricing power and robust balance sheets. Our largest holding – Telstra continues to demonstrate this via the combination of its best-in-class mobile phone network and its inflation-linked revenue stream from the NBN making up the vast bulk of the value underpinning the company. Its core competencies in Engineering – robust and widest coverage mobile network; Innovation – 5G facilitated lowest cost provider, and Marketing – consistently sustaining a 20% subscriber price premium, underpin our investment thesis.
Other examples include our holdings in Insurers – NIB Holdings, Medibank, and IAG – which should benefit from the double whammy of premium increases and increased returns from the capital and policyholder floats. Similarly, Woolworths should be a beneficiary of moving the same amount of boxes for higher revenue and earnings.
More recently, we have taken advantage of lower volatility pricing to buy portfolio insurance (for the 5th time since inception) through 6 month puts on the overall market. While we hope that these instruments expire worthlessly, we feel it is a prudent strategy given the rise in systemic risk. This strategy should be seen in conjunction with our well-diversified portfolio of companies representing good businesses, sustainable business models, and competent management at attractive after-tax cash earnings yields.
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Rhett is the CIO and Fund Manager of the Pengana Australian Equities Fund, and joined Pengana in October 2007, bringing with him over 18 years of experience as an investment professional at the time.