By Jayson Forrest

Moving forward, Kieran Rooney - Senior Consultant at Evergreen Consultants - believes where it gets interesting for inflation is on the supply side.

“We’re clearly in an economic war with China and Russia. If the West has to reorganise its supply chains, that’s going to take capital,” he says. “But the problem for the West is its capital cycle is mainly focused on intangible assets, like tech.”

While a huge volume of money is poured into the tech sector, Kieran says in comparison, not much money has actually flowed into the real economy, like manufacturing, materials and energy. He says for companies, like BHP, there has generally been an aversion to spend on capex in order to expand their capabilities and capacities.

“Unfortunately, in a period where we have to reorientate supply chains and invest in energy production, the cost of capital has risen, due to central bank policies. So, in order to suppress demand now to take the pressure off inflation, we’re actually shooting ourselves in the foot by reducing our ability to fund the expansion of productivity in the years ahead.”

Hugh Dive - Chief Investment Officer at Atlas Funds Management - agrees that global economies are facing a difficult and challenging period going forward. He believes that given the current economic environment, companies that have performed well over the last 5-10 years may not perform as well in the years ahead.

Instead, he says companies that have been able to pass on inflation have done quite well. A couple of examples Hugh refers to includes packaging companies, like Amcor, and Transurban,  when on 1 July each year, its tolls go up with inflation. However, in comparison, other companies, like ASX and Woolworths, are having trouble passing on inflation, which squeezes their margins.

“The game has changed,” says Hugh. “In an environment of rising rates, companies that promise profits in the future are worth much less than those companies that are generating income, profits and dividends today.

“So, a key measure we look at in the companies in our portfolios is whether they have increased their dividends greater than inflation. We believe those companies that can pass on inflation and grow their earnings and dividends greater than inflation, will become more fashionable with investors.”  

It’s a view supported by Jay, who adds that Janus Henderson has also been focusing on companies and issuers with hard assets, like core infrastructure, such as airports, universities with strong property assets, toll roads, and sea ports. “These are terrific assets that have cashflows that are either directly or indirectly tied to inflation.”

Jay adds that in an inflationary environment, it is becoming increasingly important for advisers to protect the buying power of their clients’ savings into the future. He says most advisers are probably focused on a CPI+ 3 per cent objective.

“One of the important things that has really changed are real rates. Today, as an example, investors can buy a 2040 inflation-linked bond in Australia with a 2 per cent real rate. In other words, whatever inflation is, that particular instrument will pay an additional 2 per cent. Now, that hasn’t been the case for the last couple of years, and has really repriced this asset class.

“So, in comparison, just consider what investors have had to endure over the last 2-3 years during the TINA (‘There Is No Alternative’) environment, where they really had to pursue heavy growth assets and also, in some cases, illiquid assets, to get that premium to deliver returns, when defensive and risk-free assets were yielding sub 1-1.5 per cent.”

Therefore, with the change in real rates, Jay believes that from an asset allocation perspective, it’s more likely that investors will now shift back towards a more traditional 60/40 or 70/30 portfolio split, rather than an 80/20 growth/defensive split.

When considering portfolio construction in a high inflation environment, Kieren also believes it is crucial that advisers carefully think about their asset allocation and manager selection. While Evergreen tries to maintain style neutrality, he concedes that value and growth is a broad church, with many different types of value and growth companies.

“However, in a high rate environment, the outperformance of growth relative to value probably won’t continue, so you do want an allocation to value equities. But you have to be careful, because the liquidity cycle is turning down.”

Yet, despite this, Kieran is confident there are still plenty of quality value companies available for investors to access, which have strong market positions and continue to return good dividends to shareholders.   

Kieran believes the key for advisers when talking to clients about portfolio construction in a rising inflationary environment is to properly understand their objectives. This will enable advisers to plan better in an uncertain and volatile world.

“You have to be laser-focused on your portfolio objectives, which is usually CPI+ objectives. Advisers shouldn’t be too focused on benchmarks that don’t matter to your clients, that’s because you have to be willing to underperform certain indexes or benchmarks to allow you to manage those CPI+ objectives. And that involves having a much more diversified portfolio that can take into account a high degree of probabilities going forward.”

For Hugh, the key message Atlas conveys to clients is to look at a company’s aggregate of dividends and see if this is greater than the CPI. This approach can be used to measure the relative success of a company.

“It’s important to own companies that are growing their profits better than inflation, which enables them to distribute those returns to the underlying investors,” says Hugh.

Chamath is adamant that investors can achieve CPI+ 3 per cent with a much more defensive allocation. This means investors no longer need to take on as much credit or liquidity risk, nor do they need to stretch out into unlisted and private assets.

“You’re now earning 300 basis points more on cash, government bonds, and inflation-linked government bonds, and maybe even a little bit higher on corporate bonds compared to 12 months ago,” says Chamath. “So, there is an opportunity to de-risk portfolios now, improve their quality, and improve the overall liquidity profile of portfolios.”

While Jay doesn’t deny that the last few years have been a reasonably beneficial period for investors, he accepts it has also come with some level of discomfort, requiring investors to take risks they ordinarily wouldn’t take, like moving into illiquid markets or taking strong style biases in equities.

“However, I’d like to think that the period ahead will be more suited to higher quality, simpler asset allocation, which will actually better serve investors. And while there is still some volatility over the near-term, I don’t believe investors will have to take as much risk on a forward-looking basis,” he says.

“A lot of the secular changes around global trade, national resilience, and climate risks, will create phenomenal investment opportunities for clients, and some of these opportunities are going to be government backed.

So, when talking about high quality de-risking portfolios, there’s nothing better than buying an investment that pays a market commensurate rate of return that is partly government backed.”      

Jay Sivapalan is Head of Australian Fixed Interest at Janus Henderson Investors;

Hugh Dive is Chief Investment Officer at Atlas Funds Management;

Kieran Rooney is Senior Consultant at Evergreen Consultants; and

Chamath De Silva is Senior Portfolio Manager at BetaShares.

They spoke on ‘Has inflation peaked?’ at the IMAP Independent Thought Conference - Melbourne.

The session was moderated by Toby Potter - Chair of IMAP.