INVESTORS haven’t faced the challenge of investing in a low growth, high-inflation environment for many decades. But that’s the scenario right now.
For financial planners, equities mostly sit at the heart of a portfolio and provide long term growth. Now investors must diversify to protect portfolios, says Michael Blayney, who heads up Pendal’s multi-asset team.
Investors can think about the market in four quadrants, says Blayney:
“First, there’s good growth and high inflation. That’s not necessarily a bad thing for equities. They generally do well, whereas it’s a bad environment for bonds.
“If you have a low growth, low inflation, equities might be lagging a bit, but bonds are doing well.
“Then there’s the good growth, low inflation environment which we have enjoyed since the global financial crisis. We’ve had solid, albeit unspectacular, growth and really low interest rates and that’s been close to a Goldilocks situation for both equities and bonds.
The most challenging time to be an investor is in a low or slowing growth, higher inflation environment – the likely current scenario.
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“We haven’t seen that for a long time. That’s what happened with the dreaded stagflation of the 1970s,” Blayney says.
“That environment is challenging for bonds – they tend to get whacked early when you have the initial high inflation. Once the market adjusts and you get higher yields, they can start being a good investment.”
“Right now, Aussie bonds are about fair in terms of pricing-in higher inflation. Overall, with global bonds, the yields aren’t quite high enough. They haven’t quite priced in the inflationary environment enough.
“But it is an environment where you want to be active because if yields spike, then bonds might be attractive,” he explains.
Inflation-linked bonds are a potential option in the current environment. In their standard index form, they tend to have long interest rate duration and so can still suffer in a rising rate environment.
Blayney says a critical factor for the asset class is not where inflation has been, but where the market thinks it’s going.
“If you see the market start to expect inflation to be higher for longer, than you would expect inflation-linked bonds to outperform nominal bonds of the same maturity – though absolute returns may still be negative if the impact of rising yields is larger than the impact of the increase in longer-term inflation expectations, which has been the case so far in 2022.”
So far, the market hasn’t priced in inflation as a long-term problem, with pricing inferring an inflation rate over five years of 2.6 per cent.
Investing in equities in a low growth, high inflation environment is tricky, Blayney says.
“A higher bond yield means a higher discount rate applies to equities, so they get marked down. And you will also likely see earnings start to come off, though that hasn’t come through in aggregates of broker estimates yet.
“In periods of rising inflation commodity sectors tend to do better. Further, in periods of both rising inflation and falling growth, sectors with sticky demand and pricing power like healthcare and consumer staples have historically been good places to invest.”
The current environment highlights the benefits of diversification and being nimble, says Blayney.
It’s time to look beyond bonds and equities, he says.
“There are assets like commodity futures which have followed the pattern of the early 1970s, though have come off a bit more recently. Real assets can be attractive in the listed infrastructure space, where you can get inflation-linked cash flows.”
He warns that trying to pick exchange rate movements is not straight forward.
“The Australian dollar is a commodity currency, so all things being equal, you’d expect with commodity prices high, the Aussie dollar would be strong.
“But it’s also a ‘risk-on’ currency. If markets struggle a bit, you tend to see those currencies fall. And then there’s the interest rate factor and the US Federal Reserve has been more aggressive than the Reserve Bank of Australia. There’s opposing forces on the currency and it’s difficult to get a clear direction for the Aussie dollar.
“Financial planners should think about the things that provide portfolio diversification away from just equities. And that’s bonds, currency and alternatives.
“Unless you have a wonderful crystal ball, you need to own all of them.”
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 Allan Polley — manages our multi-asset portfolios with a focus on strategic asset allocation, active management and tactical asset allocation.
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