Preparing client portfolios for ‘sticky’ inflation
Inflation is set to be a key challenge for clients as we enter a period of core inflation which will be more difficult to budge without an economic slowdown to ‘reset’ the economy.
The key for clients is preparation, and advisers and their clients must could benefit by focusing on risk managed portfolios as the building blocks to navigate the uncertain market outlook.
Inflation shifts from goods to services
It’s not lost on me that we often fall into the trap of making changes after the fact and yet the irony with this current economic slowdown is, it is the most anticipated certainly in my more than 20 years working with markets.
We certainly all expected that post COVID the global economy would enter a recovery period and this has been the case. We entered a period of ‘goods’ inflation where, due to affected supply chains, the war in Ukraine and the spikes in energy prices, governments provided subsidies to support the economy, which in turn helped to push prices up.
While supply chains have now opened up and commodity prices are normalising, unemployment is at record lows and rents are going up due to a housing shortage. What we are seeing is that ‘goods’ inflation is transferring to ‘services’ inflation which in essence, is harder to control.
This is because the risk in services inflation is a lot stickier because it is ceded in wages and rent. In the absence of a recession or two or more quarters of negative growth, it can also take longer to get under control.
Inflation is triggering
Inflation is painful for clients, currently reducing their real purchasing power by 7-8% per annum. The impact is real and at elevated levels such as this it is a highly destructive force that needs to be reined in.
The most recent RBA interest rate hike which came as a surprise to many, not only means a 25 basis points increase, it has a ripple effect on the risk margins that the banks put on top of that which in real terms can add thousands of dollars to mortgage repayments.
And the evidence is in that clients are feeling it - shopping habits are changing. Woolworths reports more chicken than beef is now being sold because it is cheaper and people are buying their own coffee beans to limit take-away coffee purchases.
Despite a growing body of evidence that inflation is beginning to have a real impact on consumers and ultimately the economy, distorting the severity of market conditions has been the recent rallies in equity markets making it feel like there is a significant disconnect between what equity markets are pricing in and what is actually occurring on the ground.
Inflation impacts all asset classes
Increases in cash rates are the primary building blocks of asset class returns because when this happens, it has a flow on effect to a broad range of investments, with the potential to impact how they perform relative to each other.
We saw this in 2020 when equities and bonds become correlated. In this environment, many 60:40 investment strategies underperformed and at their lows, both bonds and equities were down by more than 20 per cent. This remains a major challenge for balanced and traditional investment portfolios that rely predominantly on bonds for diversifications.
However, it is not only the quantum, but also the duration and rate of the increase in interest rates that are important factors when considering asset classes’ response to inflation.
For example, when inflation and interest rates rose sharply in Australia in 2022, bonds initially repriced to reflect the outlook for higher rates and underperformed. Equities also sold at discounted rates, driven by both the move in rates and risk premiums which reflected the higher risk environment for earnings.
But as we progress further into the economic cycle and earnings come under more pressure, equities are higher risk and quality equities should do better. Bonds could present as a more effective diversifier in the event of a recession.
Broader non-traditional asset classes will respond differently depending on their sensitivity to interest rates and earnings and it is here we see some interesting opportunities, particularly versus bonds as a diversifier.
Inflation-linked securities and infrastructure, that do have the ability to pass through inflation, are less impacted and can perform relatively better. Property valuations are sensitive to capital rate increases and the cost of finance as they typically carry more debt. Unlisted property initially can provide a degree of resilience as income is sought after and transactions are slow at the beginning of a slowdown, meaning price moves can have a lag.
Currently we are seeing some listed REIT’s trading at a 30 per cent+ discount to NTA and these discounts are not being replicated in the unlisted space, so there may be a bit to play out here.
We see both private equity and credit offering opportunities but on a selective basis, and illiquidity is a key consideration and source of additional return. Meanwhile, liquid alternatives are a very broad asset class and we see opportunities to potentially do well in strategies such as trend, risk premia and discretionary macro.
Finally, commodities including gold can be an effective hedge against inflation as can currencies with the USD and Yen prospective, relative to growth currencies such as the AUD.
Risk management is the starting point
Given the different behaviour of asset classes in an inflationary environment, advisers and clients may wish to focus on how to construct their portfolios to weather all market conditions.
They are likely to benefit from a much broader universe of instruments to manage risk and derive a return, coupled with an investment philosophy and risk management process that is active and can extract value through the cycle.
In this way, risk management should not be thought of as an output of your asset class allocation, but rather as an intended strategy that is focused on diversifying the underlying risks within portfolios.
For example, in 2022 the predominant underlying risk was interest rate duration which didn’t just turn up in bond portfolios, but also equities, property, currency, long/short equity managers and credit books, so risk should be viewed on that level, not simply in terms of asset classes using bonds.
To counter this, and to help them manage risk and the drivers of returns, advisers and their clients could benefit by considering a broader universe of assets to invest in than many traditional approaches.. For us this means adopting a less constrained approach to allocating risk, leading possibly to a higher potential for achieving objectives.
This is where asset classes such as alternatives and private markets come into play, and where having investment strategies specifically around minimising drawdowns such as derivatives and currencies, can be really effective.
But it is important to not go it alone. While having an evaluation framework or risk framework is important, and there will be some great opportunities to be had, these could be limited when it takes time to move capital around, and when emotions are involved.
Emotion can be removed. Working with a trusted investment manager who focusses on risk, while deploying capital at the right time, maybe considered the optimal way for advisers and their clients to manage risk day-to-day.
Portfolio considerations when thinking about risk
1. Central banks are serious and they are committed to getting inflation down
2. The prevailing uncertain environment has been created by a myriad of factors including inflation, interest rates, bank instability in the US, and withdrawal of liquidity from markets by central banks and governments.
3. Equity markets are at a disconnect with uncertainty so while multiples have come back, earnings have not.
4. Economic volatility means a slight wobble could cause an asset repricing.
5. Risk management can be top of mind in portfolios whilst at the same time not missing out on equity rallies.
Tony Edwards is chief investment officer at Atrium Investment Management.
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