Global financial markets are unprepared for a sustained period of high inflation, exacerbated by the government handouts during Covid-19.
“After 40 years of disinflation, markets are not positioned, not prepared and not valued for a scenario where inflation could be high,” Steve Wreford, head of global thematic equity at Lazard Asset Management based in New York said.
Speaking at the Investment Magazine Fiduciary Investors Symposium in Healesville last month, Wreford said equity investors have had little precedent to navigate the current market conditions. “The problem is that from an asset allocation perspective and from an equity investor perspective, we don’t have a lot of prior regimes to go on… and equities don’t like CPI over four per cent,” he said.
However, his team of analysts at Lazard have honed on to a small subset of equities with a particular inflation-fighting characteristic within the top 2000 large and mid-cap stocks. These companies have been “materially undervalued because they have exposure to the very causes of inflation, or because of the symptoms of inflation or it’s just some quirk of their business model that means their profits go up when the rest of the markets are going down in an inflationary environment,” he said.
Cutting exposure
The equities team at the $260 billion industry fund AustralianSuper have lowered exposure to equities, moving into fixed income and cash to navigate through the higher-than-average inflation environment.
“One of the simplest ways to make the overall balance plan more resilient to an inflationary world is actually to reduce exposure to equities, which is one thing that we’ve done quite a lot of just in the last six months or so,” AustralianSuper head of equities Justin Pascoe said.
“We are probably at the lowest exposure to listed equities that the fund has been in for probably since the global financial crisis.”
Equities at AustralianSuper is split between Australian equities, international equities and private equity, representing between 50-and 60 per cent of the asset book. The Australian equities portfolio is largely internally managed and concentrated in about 50 Australian companies.
The fund manages its international equity portfolio through moving “money across building blocks of both international and external strategies” depending on the economic cycle said Pascoe.
“Breaking that down into four distinct phases, recovery expansion, slowdown recession, we think we’re heading into a recession and there’s not too many places to hide,” he said.
“But through a recovery type phase, you want to be in longer cyclical type stocks and then into an expansion and then slowdown, growth is your friend.”
While defensive stocks have historically performed better in a recessionary environment, stock prices are not cheap and may dilute the resilient value to the portfolio he said.
“If what you’re buying [is expensive], it’s not going to give you the protection that you would otherwise be wanting from shifting your portfolio defensively.”
Constructing resilience
TelstraSuper has built in resilience in the construction of its equities portfolio to partly counter inflationary pressures but mostly to achieve a “smoothed” excess return profile.
“The way the portfolio is constructed is to actually create a resilient profile over the long term and that’s predominantly because the structure of each market is different,” said Dominique d’Avrincourt, the super fund’s head of equities.
“The Aussie market is dominated by resources and economically sensitive sectors and the global market, which is mostly US, is dominated by structurally growing sectors.”
“We’re happy to have tilts and biases where it makes sense, and it makes sense to have a quality growth bias in a global portfolio that’s dominated by structurally growing companies. Equally it makes sense to have a value dominated portfolio in Australia, which is dominated by value type industries.”
Like AustralianSuper, TelstraSuper has reduced the listed equities component of its portfolio to the lowest level relative to its strategy asset allocation.
The fund also employs derivatives or physicals as a risk mitigant for unintended short-term biases. D’Avrincourt said the fund bought a basket of the top six largest oil companies in the developed markets to mitigate the underweight position to the energy sector in its portfolio.
“The way we have structured the portfolio is having a long-term physical portfolio that’s relatively stable through time, reflecting our philosophy and risk mitigating through that period if there is significant macro event risk or dislocation,” she said.
“We reduced the short energy factor risk to increase the resilience of the portfolio to the near-term oil shock and geopolitical risk.”
Emerging markets hold up
Emerging markets such as Brazil, China, India, Indonesia and Vietnam have weathered inflation well said Joseph Lai, chief investment officer at Ox Capital.
“If we look at the inflation rate of these countries, relative to where they have been last 10 years, it’s barely a blip. These countries can deal with inflation, and they’ve been dealing with it forever.”
Emerging market countries have also not incurred significant government spending during Covid-19 and so “debt to GDP is actually quite manageable,” he said.
Countries such as Vietnam are experiencing double digit growth in exports at a time when the world’s economy is slowing down. “Incremental shifts of new dollars spent are going to these countries such as India, Indonesia and Vietnam. That’s what is driving is growth of exports,” Lai said.
Separately, Indonesia has ambitions to be the world’s largest nickel producer and a manufacturing hub for electric batteries on the back of Chinese low carbon technology.
“[These developments are] a result of the change in global dynamics, the spillover of the supply chain movement and the reforms that have taken place in these countries over the last 10 to 20 years,” he said.
