THE MAJOR global economic debate right now is whether the recent jump in prices in the US, Europe and other parts of the world including Australia, is transitory or structural.
Central banks remain convinced it’s transitory, though a few around the globe have taken steps to taper bond-buying programs. More than 25 central banks — mostly in emerging markets — have raised interest rates so far this year.
It remains to be seen whether we look back on the “inflation is transitory” line as we do now on the Fed’s “sub prime is likely contained” line in 2007.
“You can go through both sides of the argument, but in portfolio construction, that’s not the main point,” says Michael Blayney, head of Pendal’s multi-asset team.
“As an investor you are faced with a huge amount of uncertainty as to the inflation outlook … and it’s about building a portfolio that’s robust to a range of outcomes.
“Portfolio construction has to link back to a client’s objectives and make sure it can handle different scenarios.”
The difference now, compared to the global financial crisis in 2007-08, is the amount of money in the system thanks to government spending, support payments and money creation, Blayney says.
Back then monetary policy was loosened — just as it is today — but fiscal policy was much tighter.
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“There’s an awful lot of money sitting in people’s bank accounts — I’d say an unprecedented amount. It’s hard to imagine it’s never going to get spent. Also, fiscal policies are considerably looser around the world. And we’re starting to see price pressures.
“Last week’s US employment data disappointed with fewer new jobs being created last month, but wages still rose. You also have businesses wanting to de-globalise and bring supply chains closer, which might mean having to accept higher prices.
“If you think about all these things, it might mean you sit in the structural camp or the transitory camp. But what you need to think about is balancing portfolio construction risks over range of scenarios,” Blayney says.
Bonds don’t do as well as a portfolio diversifier in an environment where you see unexpected increases in inflation, he says. And if authorities need to tighten monetary policy you could very conceivably see a period where equities and bonds suffer together.
“When the inflation genie gets out of the bottle, traditional bonds become more of a problematic asset, at least initially. It means you have to be dynamic in your asset allocation.
“For example, if bonds sell off a bit because of inflation that might be a good entry point. Once inflation is priced in, it allows you to buy bonds at higher yields. Of course, it means you have to be comfortable not always holding lots of bonds in your portfolio.”
“You can hold cash, but that’s yielding virtually zero (which is around -2% real). So, you need to look at alternate asset strategies,” Blayney says.
At their broadest, such strategies included everything that isn’t bonds or equities. These strategies can also get access to inflation-linked assets such as commodities and other “inflation-hedging” strategies that are difficult for investors to implement directly themselves.
“There’s liquid alternatives strategies, which rely very much on the manager’s skill and more dynamic management of the fund,” he says. “They tend to be more active and use a lot of relative value type trades with the goal of providing diversification and returns.”
Liquid alternatives involve assets that are easy to buy and sell (liquid) and typically exhibit a lower correlation with traditional stock and bond investments.
Infrastructure and property are other options.
While both are sensitive to rising bond yields they are real assets. Underlying cash flows for many of these assets are linked in some way to inflation through rents (in the case of property), power prices (in renewable energy) or other long-term, contracted inflation-linked revenue streams.
“If you’re worried about sustained, long-term inflation, property, infrastructure and listed alternatives are all good assets to have in your portfolio,” Blayney says.
Michael Blayney leads Pendal’s multi-asset team. Michael has more than 20 years of investment management and consulting experience. He was previously Head of Investment Strategy at First State Super and head of Diversified Strategies at Perpetual.
Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.
The team — which also includes Stuart Eliot and Allan Polley — manages our multi-asset portfolios with a focus on strategic asset allocation, active management and tactical asset allocation.
This article has been prepared by Pendal Fund Services Limited (PFSL) ABN 13 161 249 332, AFSL No 431426 and the information contained within is current as at September 8, 2021. It is not to be published, or otherwise made available to any person other than the party to whom it is provided.
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