At a time when the US is “choosing inflation”, in the memorable phrase of DWS Investments consultant Pippa Malmgren, funds managers are wheeling out new products designed to withstand a higher CPI, or at least emphasising old products they think can do likewise. MICHAEL BAILEY explores some options for investors sitting on vulnerable cash.
Provided they’ve got the product mix to do it, many funds managers are positioning themselves for a global return of inflation, and none in Australia are doing so with more gusto than DWS Investments, the retail asset management arm of Deutsche Bank. “Strikes are back!” exclaimed Dr. Philippa Malmgren, the global financial services policy expert and external advisor to DWS, at the Sydney launch last month of a white paper on investment strategy in an inflationary environment.
Apart from the well-known drivers of future inflation, such as growth of consumption in ‘Chindia’ and overhang from the overtly expansionary monetary policies of 2002-07, Malmgren said that pressure on wages tended to be highest when booms had passed. As evidence she pointed to the “massive gap” between the wage increase demands of Boeing’s 26,000 engineers and machinists and the increase that management was prepared to provide, which started out at 19 per cent plays 4 per cent, and despite moderating since then looked certain to lead to major strikes last month.
Adding to the inflationary pressure were little-publicised Barack Obama policies making it easier to unionise, Malmgren said, at a time when the US Federal Reserve was already actively stimulating inflation by running negative real interest rates (if the ‘core’ inflation figure which includes food and energy is the one used). “Do you really want to hold US Treasuries if the US is choosing inflation?” she asked. DWS investments specialist, Bill Barbour, made it clear the house view was not “hyperinflation…but we do believe there’ll be a sustained period where inflation will run a good 1-2 per cent ahead of central banks’ preferred bands.”
Pointing to the same Morgan Stanley graph pictured here, Barbour said that periods of strong economic growth as the world had just witnessed were often accompanied by higher general prices for goods and services and thus higher prices for commodities. While noting that equities and bonds suffered overall, Barbour added that “periods of high inflation can provide opportunities for some companies to do well…these could include companies with few competitors, sales exposure to high-growth sectors in emerging markets such as infrastructure and consumer goods, those in regulated sectors which will allow revenues to increase in line with inflation, and those with links to real assets such as hard and soft commodities, precious metals, oil and gas, and real estate.”
Barbour said that infrastructure companies held many of these characteristics, pointing out for example that high commodity prices had driven European power prices to record highs in the current cycle. He added that quality companies with moderately high levels of debt, strong cash flows and interest cover were likely to benefit from higher inflation, because the real value of their outstanding debt was eroded.
Barbour wouldn’t find too much disagreement from David Iben, the chief investment officer of Tradewinds Global Investors (whose global equities fund recently became a standalone offer through Advance Asset Management) even though (unlike DWS) he’s a long-only manager with no infrastructure or agribusiness funds in the stable.
“We don’t like companies with 10,000 competitors that can’t pass costs through – we like oligopolistic things like railroads, utilities, farm equipment,” Iben said from his Los Angeles base last month. “Resources obviously do well in inflationary times, but you don’t have to be a believer in inflation to like buying five dollar’s worth of coal for $1, or $1000 of gold for $800”, he continued, referring to the currently depressed prices of some resources like copper, nickel and gold. “You’re buying a free call option that inflation will lead to higher prices.”
There are three reasons why traditional portfolio allocations can lead to sudden, large drawdowns, according to the chief executive of multi-asset house Mellon Capital Management, Charlie Jacklin.
One is that they tend to be overconcentrated in equities. The classic 60:40 portfolio split is anything but “balanced”, according to Jacklin, because the variance of equity returns ends up explaining 90 per cent of the variance in the entire portfolio, and that’s not good when inflation might be on its way back up.
For example between 1973 and 2007, the US experienced 16 years where the actual inflation rate was higher than the year before. The S&P 500 produced an average annual real return of -2.5 per cent during those years, while the Goldman Sachs Commodity Index delivered a handsome 26.4 per cent.
Inflation is much friendlier to shares – during the 19 years of decreasing inflation, stocks did 16.2 per cent while commodities lost 5.9 per cent. Jacklin’s other two reasons for balanced funds occasionally losing a lot of money are somewhat related – he believes they are underinvested in a sufficiently diverse range of global markets, and that they contain insufficient protection from inflation shocks. “If you think your home economy is entering an inflationary period, sending money offshore is a hedge because your home currency will tend to depreciate,” he says.
Mellon Capital Management has developed a new ‘Advanced Beta Strategy’ specially made for more inflationary times, which in a reflection of the DWS stance outlined earlier, will purchase a diverse range of commodities to provide downside protection as the cost of living begins to creep up. The asset mix attempts to become more inflation-friendly via the use of Treasury Inflation-Protected bonds (TIPs) and real estate, Jacklin added.
Apart from the appearance of products like Mellon’s ‘Advanced Beta Strategy’, another sign of inflation’s return is when investors with no interest in macroeconomics begin to notice it’s influence in their portfolios. Cliff Asness, the Goldman Sachs propellorhead who turned his penchant for applying value and momentum signals into a lofty reputation with the shop he founded over 10 years ago, AQR Capital, finds his computer has a liking for ‘linkers’ (as TIPs are often called) at the moment. “I’m a quant so I only ever have a 53 per cent conviction about any particular asset class, but if I look at the entrails of our models it’s implicit that we think inflation will be higher,”
Asness told Investment & Technology while visiting Australia last month. “The way nominal bonds are priced at the moment, either the market has made a bad call on inflation, or they desperately want the safety and are prepared to wear the lower returns, or I am dead wrong – a possibility which can never be discounted!”