Alan Polley: Transitory or not, inflation is undergoing long-term structural change

Investors should prepare for a long-term structural rise in the rate of inflation, regardless of how the current economic cycle plays out, says Pendal’s ALAN POLLEY

• Short-term debates about inflation doing a disservice to investors
• Look through the cycle; higher prices are here to stay
• Inflation-proof portfolios needed to ensure long-term real returns

DEBATE about the transitory nature of the current inflation cycle is just a distraction for genuine long-term investors, who should look beyond the short-term economic cycle, says Pendal portfolio manager Alan Polley.

Over the next decade, many of the big drivers of lower prices from the past — including the globalisation of manufacturing, government fiscal austerity measures and cheap fossil fuels — will start to unwind.

This means investors need to prepare portfolios to weather the return of rising prices.

In the long term, inflation is now more likely to align with central bank targets — rather than fall materially short as it has over the past decade, says Polley.

Going forward, there’s also more risk of inflation spikes compared to the past decade. 

“Over the last decade inflation has materially undershot central bank targets, independent of this transitory-or-not debate,” says Polley, a portfolio manager in Pendal’s multi-asset team.

Inflation at a turning point

“Right now, we’re at a flux. The long-term outlook for inflation is at a turning point. The drivers of lower inflation over the last decade are starting to unwind.”

This inflection point for inflation means the dialogue occupying markets at the moment “is quite misguided”, he says.

“Whether the current bout of inflation is transitory or not doesn’t really matter.

“What really matters to long-term investors is not what happens in the short term.

“What investors should really be worrying about is the implications for long term inflation.”

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Polley identifies five drivers of lower inflation over the past decade:

• A higher propensity to save amid stalling economic growth
• Higher rates of globalisation
• Advances in technology
• Low labour bargaining power, and
• Deep underemployment in many western economies

But in the coming decade, a new set of forces will conspire to put upwards pressure on prices.

First among the changes is the unwinding of the rate of globalisation, says Polley.

“Pretty much all the developed economies have been comfortable outsourcing their manufacturing to lower-cost countries like China.

“But geopolitical and national security concerns mean the rate of outsourcing is going to diminish — or at least become less efficient.

“World governments are starting to understand the risk as China starts to flex its muscle.

“And increased income inequality in developed nations — resulting from a hollowed-out and unhappy middle class with zero real income growth — will need to be politically and practically addressed.

“Onshoring manufacturing and finding alternative suppliers to China will drive a reduction in the rate of globalisation and thus the global supply of labour.”

At the same time, the world’s move away from fossil fuels will impose new costs through the global economy, from the expense of building a new renewable energy system to an increasing carbon price on emitters.

“We won’t be able to rely on cheap fossil fuels going forward — that means energy prices will go up.”

Government policies are another new driver of higher price pressures as the post-GFC austerity policies give way to a political willingness to run higher deficits and monetary policymakers allow inflation to run higher than previously.

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“In the past, when inflation gets to the US Fed’s 2 per cent target, they start to raise rates,” says Polley.

“That biases inflation low because they never let inflation get above the target.

“Now, they are saying they are going to let inflation run hot, which by definition means inflation will be higher on average than it was in the past.”

Policymakers also have an incentive to allow inflation to run higher because it is the most effective way to reduce the value of high government debt.

“The monetary policy punchbowl won’t be removed when the party starts to warm-up — and it may be further spiked with fiscal policy.”

How to position portfolios now?

So, how should genuine long-term investors position their portfolios for the end of low inflation?

Polley advises focusing on assets that have long proved to be protective against higher prices: commodities, inflation-linked bonds, real assets and equities, especially value-based stockmarket strategies.

“You could also look for investment products that have the objective of delivering a real return after inflation,” he says.

Ultimately, Polley suggests investors leave the debate over the immediate inflation outlook to their fund managers.

“As an investor, focusing on short-term market gyrations just gets you distracted from the main game which is your real long-term investment returns.”

About Alan Polley and Pendal’s Multi-Asset capabilities

Alan is a portfolio manager with Pendal’s multi-asset team.

He has extensive investment management and consulting experience. Prior to joining Pendal in 2017, Alan was a senior manager at TCorp with responsibility for developing TCorp’s strategic and dynamic asset allocation processes covering $80 billion in assets.

Alan holds a Masters of Quantitative Finance, Bachelor of Business (Finance) and Bachelor of Science (Applied Physics) from the University of Technology, Sydney and is a CFA Charterholder.

Pendal’s diversified funds provide investors with a variety of traditional and alternative asset classes and strategies.

Find out more about Pendal’s multi asset funds:

• Pendal Multi-Asset Target Return Fund
• Pendal Sustainable Balanced Fund
• Pendal Sustainable Conservative Fund

Contact a Pendal key account manager here