Market pricing suggests consensus expectations for inflation to normalise back towards target over the next few years; 10-year inflation breakevens in the UK stand at 4.1 per cent, and in the US at 2.6 per cent. That optimistic scenario may be proven right, but the upside risks to inflation have been persistently underestimated for the past 18 months already.
Most market participants have not invested through this sort of environment, and it seems likely that they are overly anchored in the recent, secular stagnation era.
Stagflation or not, it is important to consider how to construct a portfolio to be resilient through a period of elevated inflation, weak growth and structurally higher interest rates than those of the post-GFC era. What is the new playbook?
We continue to advocate higher allocations to property and infrastructure, with a focus on those with more explicit inflation protection built into their revenue or cost structures.
Despite recent outperformance, carefully selected assets in these areas offer higher and relatively more stable yields across a range of scenarios, compared with nominal bonds, which despite this year’s sell off still offer negative real yields and warrant lower allocations than in past cycles.
It is hard to have the same confidence in commodities, given their inherent volatility and lack of yield. Gold is very different though and deserves an allocation, given its proven ability to deliver positive real returns over centuries and its reliable diversification and crash protection credentials.
Another adjustment to consider for a period of persistently high inflation is to increase allocations towards value stocks and tilt away from growth stocks.
On average value stocks – usually characterised as lower growth businesses and often found in sectors such as energy, utilities, financials – are more asset-heavy and less sensitive to rising interest rates. Indeed many financial stocks will be direct beneficiaries of higher rates, so accordingly have outperformed growth stocks this year.
The post GFC environment saw high growth and tech stocks outperform for the best part of a decade, and valuations become incredibly stretched relative to value stocks – but a new and wholly different regime could result in very different patterns of market leadership.
Balance sheet strength and pricing power – the ability to pass on price rises despite tough economic conditions, will be vital, and evidence is already beginning to emerge of a period of creative destruction, as zombie companies that benefited from the era of cheap money will fall by the wayside.
In such an uncertain and unusual environment, it is also likely that volatility would remain elevated, which would play into the hands of active managers and hedge fund strategies.
Low inflation and low rates equated to equity markets being narrowly driven for many years, making passive strategies much harder to beat, but what we have seen this year may become more of the norm, with greater dispersion creating opportunities for the best active strategies to outperform. Multi-strategy hedge funds have been one of the few sources of positive returns this year.