Do You Really Need to Inflation-Proof Your Portfolio Now?
The following piece was originally published in Livewire on 4 March 2021.
Here's a question: How do you adjust your portfolio to tackle inflation? And here's another: why would I ask such a thing, now of all times?
Well, because inflation, the investors' bogeyman, is all the markets seem to be able to think about at the minute. Indeed it seems to have portfolio managers from here to Wall Street up all night wondering if and when it will come for them.
That's the buzz at any rate. But do you really need to inflation-proof your portfolio now?
Certainly, there are signs inflation is here, or near: commodities are booming, asset prices are rising, tech stocks have surpassed bubble-levels and bond yields are curving hotly upward. And yet, the usual metric for inflation, CPI, is languishing at a measly 0.9%.
Paul Singer, the founder of hedge fund firm Elliott Management, seems to think inflation is inevitable. In a recent interview for Grant Williams, Singer said the banks are on the "road to destruction" through a super-low interest rate environment and spending trillions on COVID-relief stimulus.
But then, the central banks agree to disagree. US Treasury Secretary Janet Yellen recently argued the need for an additional US$1.9 trillion in stimulus (now sitting with the US Senate), while Jerome Powell, Chair of the US Federal Reserve, has tried to calm markets with a "lower for longer" rhetoric. Closer to home, RBA Governor Philip Lowe has explicitly said he does not expect inflation to reach the RBA's target of 2-3% until 2024.
So, with all these differing views emerging, we asked fund managers from a range of portfolios, through Fidante Partners' global network of investment experts, whether or not inflation was causing them concern, and, if it was, just what are they going to do about it?
Meet our experts
- Sinclair Currie Principle and Co-portfolio manager for NovaPort Capital
Focus area: Small-caps
- Justin Webb, Head of Investment Solutions at Whitehelm Capital
Focus area: Infrastructure and infrastructure debt
- Adrian Warner, Managing Director and CIO of Avenir Capital
Focus area: Global equities
- Alex Stanley, Relative Value Strategist for Ardea Investment Management
Focus area: Fixed income
Reading the signs
When we talk about inflation as a nightmare situation, we aren't talking about central bank targets of 2-3%. Instead, we are referring to inflation which takes off and cannot be controlled. It's when inflation catches markets off guard or reaches levels of hyperinflation that we're really concerned about. While we're all seeing the same signs in the market, our experts are all reading the signs and have varying opinions.
1) Signs of high inflation:
- Reduced globalisation: "In the US there is a more hawkish view of trade and in Europe, they're looking at carbon border taxes. These are a bit anti-globalisation. The globalisation which we've been hoping will hold down inflation for many, many years is not going to be such a big force going forward, simply because it's already played out," said Sinclair Currie from NovaPort.
- Lots of government spending: "We saw this enormous increase in the federal budget deficit in the US. In three months, the US deficit increased by more than the cumulative total of the past five recessions - the recession of the early 70s, early 80s, early 90s, the dot-com bust, and GFC. In those three months, the deficit increased by a larger amount than the sum of those five recessions," said Adrian Warner of Avenir.
2) Signs of low inflation:
- Breakeven inflation rate is quite low: "On a long run history, the 10-year breakeven inflation rate of 2% is actually quite low," said Alex Stanley, Ardea. "If you also consider what the RBA targets for inflation - 2-3%, really what the markets are telling you is that inflation will barely average the lower end of the range the RBA targets over the next decade."
- We're coming off a low base: "There are one-offs in those inflation numbers because we're coming from a period in COVID-19 where there were very depressed prices, so what we're seeing is an unwind of those discounts. Oil is a classic example of that," said Justin Webb.
- There's lots of spare capacity in the economy: "The RBA is focusing on other things that drive inflation, like wages. Wages are currently at 1.4%, you've typically needed to see over 3.5% in order to get wage pressures that feed into inflation," said Stanley. "You've got unemployment running at 6.4%, and you tend to need to see that well under 5% to start to see some upward pressure on inflation," said Stanley.
So if high inflation does hit, what should you do about it?
"If you're trying to work out what to do when the problem has arisen, you're too late. So you have to be prepared beforehand," said Warner.
"It's prudent for markets to be anticipating some lift in inflation. It just has to be recognised that it's a very low level," said Stanley.
One of the great fears about inflation is how we've dealt with it in the past. When inflation strikes, the central banks hit the breaks by increasing interest rates, and an oft-quoted Buffettism is "interest rates are like gravity to markets". In the mid-1970s, inflation reached 11%, and the S&P500 had fallen 40%.
But there is still much which can be done for your portfolio.
Some assets will benefit from an inflationary environment
Webb said, as a general rule, inflation is a positive forum for infrastructure assets.
"If inflation comes through it can amplify the cash flows you get out of the asset - which is certainly a net positive for the asset," he said.
"A good example of this is toll roads which have their pricing model directly linked to CPI, or regulated utilities, such as water or electricity, as inflation is typically a direct input to their allowable return.
However, he caveats this by noting it is not a one-way street, and that along with other long-duration assets, infrastructure valuations have benefitted from the continued lowering of interest rates over the last 10 years.
Look for companies with pricing power
Currie believes that no matter when inflation hits, you should be invested in a high-quality business with pricing power.
"The worst thing you could end up with is, one - sales constrained because of low inventories and, two - you're unable to maximise your price," he said.
"You have to think long and hard about what sort of environment you expect everyone's going to be in the next two years and make sure your portfolio isn't overly weighted to longer duration equities such as really high growth stocks."
Take the barbell approach
Warner had three clear tips for investors:
- Avoid the most expensive parts of the market: "There are a lot of companies out there that have become these market darlings and driven to very, very high levels," he said.
- Avoid "dividend aristocrats": high dividend, but low growth companies. He said: "We think these companies have had their day in the sun and could be a dangerous investment if inflation strikes and interest rates go up.
- Take the "barbell approach": on one side of the barbell stack irreplaceable assets or monopolistic companies with strong cash generation and benefitting from secular growth, and balance the other side with companies that can benefit from an economic recovery.
Relative value strategies exposure as a safe haven
Fortunately for Stanley, exposure to inflation hedges and relative value strategies that don’t depend on higher or lower levels of yields are beneficial in this higher inflation scenario.
"The real danger is if inflation accelerates beyond a moderate level, we risk transitioning to a ‘bad inflation’ narrative...This would have negative consequences for risk assets and nominal government bonds," said Stanley.
"We don't try to predict inflation and we don't know when or how inflation might occur. But we just think it's getting increasingly reckless not to consider it as a possibility," said Warner.
Predicting inflation is a fool's game. (Arguably, writing about it is one too.) However, with all the forces at play for inflation, there are a few recurring themes. Find companies that will hold their pricing power. Seek companies with good fundamentals, or failing that, at least let them hold a monopoly/duopoly over the market.
"We're trying to make sure we have a portfolio that will handle all-weather, and that includes a breakdown of inflation," said Warner.