15 Aug 2022
Investors around the world have been consumed with the question of inflation. Will it prove a self-correcting problem and return to the benign levels of the recent past? Will Central Banks tighten policy, slow demand and bring inflation under control? Or will Central Banks tighten policy but blink at the first sign of asset price weakness or slowing growth?
At its recent Investment Institute Forum, Ninety One brought together a panel of experts to discuss the risks and opportunities presented by these different scenarios and what that could mean for portfolio allocation.
The panel, chaired by James Elliot, Head of Multi-Asset and including Tom Nelson, Co-head of Thematic Equity, Clyde Rossouw, Co-head of Quality and Alessandro Dicorrado, Head of Value did not always agree. Suzanne Lubbe, an equity-focused asset class specialist with Mercer Investments brought a measured message to the conversation.
The panelists agreed that a scenario where the US Federal Reserve was consistently behind the curve, leading to rising or volatile inflation, could be very damaging to economies around the world.
On the other hand, some inflation, which supports nominal growth, is welcome. “What you need is predictable inflation; unpredictable inflation – volatility – is not good for anyone,” says Alessandro.
Good businesses, with pricing power, will fare well in this environment. “If you are selling products and services that people need, your business has inbuilt inflation resilience,” adds Clyde.
But we are in uncharted waters. Energy price inflation may be more persistent than many realise, says Tom. “Energy transitions – such as the current move to a low carbon economy – are inflationary by nature and that situation is being compounded by the Russian war in Ukraine”.
If energy prices stay high, a reasonable assumption given the supply constraints, then returning to a low cost of capital environment seems unlikely.
This begs the question of which asset class will provide the best returns, and if it’s equities, which style would serve an investor best.
Clyde was firmly of the view that equities will beat bonds hands down. In an inflationary world, ‘inflation-proof’ businesses, in other words those that have pricing power, low debt and good free cash flow provide a better yield than a bond. Bonds, he says, are “guaranteed to lose you money in real terms because they cannot compete against inflation.”
James wasn’t convinced. “When it comes to bonds, it’s a question of whether the terminal rate is accurately pricing the likely long term inflation outcomes. I think there are very different outcomes in the next ten years in some countries relative to others.”
On the subject of equities, not all styles are equal. Alessandro noted that the last three years have not been good for value investors, apart from those in the energy and materials space. “You need stability – even if inflation is higher than usual – if its predictable – value does quite well.”
Where things get interesting is in the commodity sector.
“Natural resource companies across energy, mining and agriculture have a vital role to play in getting us to a lower carbon future,” says Tom. In some cases, the opportunity presents itself because they need to decarbonise – like traditional oil and gas companies; in others it’s because they have the potential to develop green hydrogen, renewable energy or carbon capture products and solutions; in others it’s because they have the metals and materials necessary to build renewable energy infrastructure or support sustainable agriculture.
Many of these resource companies are sitting on low valuations because they don’t tick the ‘low carbon’ box. But, says Tom, should they demonstrate that they are not the villains of the piece, and are the ‘solutions providers’ then valuations could reverse. “I would argue that valuation arbitrage where you can buy a diversified mining or oil and gas company on 4x earnings today is potentially a huge opportunity.
“There is the making of a structural bull market for aluminium, steel, copper, nickel, zinc, lithium,” he adds. Meanwhile the oil and gas groups face an existential crisis – they either transform their business models and divert the enormous free cash flows they are earning into new business streams, or they will get stuck.
“There is an industrial revolution in the industry.”
Another risk to financial markets, which is currently unfolding, is growth risk. “In my view, this is the bigger risk to the economic environment,” says Clyde. The inflation risk is well known, and Central Banks are chasing that. But what happens to earnings growth and economic growth in the second half of this year, he asks? “How deep is the valley and which companies are worst exposed?”
Suzanne brought a measure of sobriety to a lively debate. “We don’t know how each scenario will evolve. Asset owners have to take a longer-term view and the best asset owners are those that are not tilting towards or away from inflation.”
She provided some guiding principles on how to build a robust portfolio:
Lastly, she added, “we employ asset managers to manage portfolio risk appropriately. But as asset owners there is a duty on us to do that too. It is important to understand the role of each manager, and the role that each strategy plays in the overall portfolio. Are they doing what they should be doing? We must understand when they will outperform or underperform and then size their positions appropriately in the overall portfolio.” Wise words indeed.
Investments involve risk; losses may be made.