Achieving real portfolio returns in inflationary times

By Jayson Forrest

Cameron Gleeson (Betashares) and Glen Foster (Atrium Investment Management) discuss why investors should focus on real returns in times of inflation.

Lukasz de Pourbaix (Fidelity International) explains why investors should consider contrarian strategies in a portfolio.
Cameron Gleeson is Senior Investment Strategist at Betashares
Cameron Gleeson - Betashares
Glen Foster is Head of Risk, Senior Portfolio Manager at Atrium Investment Management
Glen Foster - Atrium Investment Management
Robbie Lew — Manager, Multi-Asset at Lonsec.
Robbie Lew — Lonsec.

With growth and inflation expectations being the cornerstones for the outcomes of your portfolio, you need to take into account these expectations in order to help smooth returns. That’s what genuine diversification is about. In contrast, adding assets that become correlated, only increases your risk without increasing your return

Glen Foster

Building portfolios that are resilient to changing market environments — as seen in 2022, when both equities and bonds experienced a sharp drawdown due to inflation — can be challenging for both asset allocators and investors.

Speaking at the 2024 IMAP Portfolio Management Conference in Melbourne, Glen Foster — Head of Risk, Senior Portfolio Manager at Atrium Investment Management — believes both growth and inflation are the cornerstones of investment strategies and the drivers of outcomes for investors. He says it’s important for portfolio managers to have a view on growth and inflation, and not be passive about inflationary regime shifts.

As a risk targeted investor, which seeks to get paid for the risk it takes, Atrium Investment Management seeks to be genuinely diversified across its portfolios, including different potential outcomes for these portfolios.

“You have roles for all of your assets and strategies in your portfolio. Diversification is not just adding more assets or strategies to your portfolio, it’s actually about having the assets and strategies play a role in the portfolio that’s aligned to your views,” says Glen.

As an example, he cites the economic environment in 2022. Going into that year, the yield on nominal bonds was close to zero, and there was a potential inflationary regime shift, due to a range of reasons, like supply chain disruption.

“In that scenario, you could see the risk was higher than usual and the return was lower than usual. So, to avoid that risk, you want to be flexible and unconstrained in your portfolio, and take risk elsewhere where you can get paid for it,” says Glen.

“Therefore, with growth and inflation expectations being the cornerstones for the outcomes of your portfolio, you need to take into account these expectations in order to help smooth returns. That’s what genuine diversification is about. In contrast, adding assets that become correlated, only increases your risk without increasing your return.”

Thinking about portfolios, we believe the biggest risk is a continuation of higher than desired inflation. So, when building a portfolio, we build with low cost, broad market beta exposures, which we also complement with smart beta.

Cameron Gleeson

A hedge against inflation

Ask Glen for his opinion about the best long-term hedge for inflation and it’s simple — equities. However, he concedes equities are less effective as a hedge over the short-term, because “what drives equities is future growth, discounted by how much risk and inflation there is”.

Other inflation protected assets that provide a hedge against inflation, whilst allowing investors to achieve their real return objectives, include: gold, cash, and Treasury Inflation-Protected Securities (TIPS). However, Cameron Gleeson — Senior Investment Strategist at Betashares — believes TIPS aren’t a short-term strategy. Instead, he recommends investors who want to use them as a way to hedge inflation, do so over a much longer time horizon.

When considering inflation, Glen acknowledges that Australia is uniquely positioned to the rest of the world, with high immigration levels helping to rebuild the workforce and stave off labour supply shortages.

“Australia’s economy is different compared to the U.S.,” says Glen. “If you can import skilled labour, you solve many productivity risks to the economy, and you can run the economy at a higher level.”

However, he cautions that because Australia has a floating currency, we do import inflation. “So, if there is inflation globally, we’ll have inflation in Australia. But our increased immigration numbers will help stabilise Australia over time, which means there will be less of a risk premia attached to Australian equity and bond markets.” 

As a long-term hedge for inflation, Glen believes equities have been priced in by the market as part of a ‘Goldilocks’ scenario. This soft landing, where growth continues above trend and both inflation and interest rates are lower, supports higher valuations and fair value for equities.

As for inflation, the market has also priced in a return to ‘lower for longer’ scenario.

“Prior to this inflationary period, we had a deflationary experience, where central banks ran cash rates at close to zero. What markets are pricing in now is for a potential return to lower inflation and rates, and therefore, lower risk premia in equities. This also means a lower bond/equity correlation, which means higher, fair value for equities and therefore, higher prices.”

In contrast, Glen believes the likelihood of two other scenarios playing out are much lower. These are:

* Slowdown — where earnings are slower, inflation settles higher, the bond/equity correlation is higher, risk premia moderates, which means lower fair value for equities; and

* Hard landing — where growth falls, inflation is sticky, and risk premia increases, meaning lower fair value for equities. This is a low probability scenario.

Cameron is also confident that overtime, inflation will recede. He points to the long-term expectations of the Federal Reserve’s neutral rate, which is 2.5 per cent and its inflation target is 2 per cent. This suggests the Fed believes it needs to remain about 50bps above inflation on a neutral basis throughout the cycle.

“We see U.S. economic growth as being resilient and the U.S. economy as very dynamic,” says Cameron. “We also believe we will have a ‘soft landing’. We don’t necessarily think economic growth in the U.S. will be strong but the U.S. economy is the driver of world markets, and inflation will come under control.”

What markets are pricing in now is for a potential return to lower inflation and rates, and therefore, lower risk premia in equities. This also means a lower bond/equity correlation, which means higher, fair value for equities and therefore, higher prices

Glen Foster

Market considerations

When considering the market cycle, Cameron also agrees there are two key drivers for markets: changing expectations in economic growth and inflation.

When considering an overheated environment, like in 2022, where you have stronger than expected economic growth and a high inflationary environment, this is the type of environment that suits some parts of equity markets, like cyclicals and companies that have pricing power they can pass on to customers. These companies tend to do well in that environment.

“Thinking about portfolios, we believe the biggest risk is a continuation of higher than desired inflation. So, when building a portfolio, we build with low cost, broad market beta exposures, which we also complement with smart beta,” says Cameron.

An example of this is QUS — an S&P 500 Equal Weight Index. This is done because the market cap index is somewhat biased to tech and growth, whilst the Equal Weight Index is more skewed to cyclicals, which helps to address some of the risk in an inflationary environment.   

However, Cameron believes the trickiest environment to deal with is stagflation, which is the hard landing scenario that Glen refers to.

“In that sort of environment, you have falling economic growth, and you have high and persistent inflation. And while we have a low probability for that scenario playing out, geopolitical risks do tend to crop up in this type of scenario,” says Cameron. “What we believe has occurred over the last few years has been a demand-side shock, but what is likely to lead to a stagflation environment is more of a supply-side shock, particularly with the cost of energy increasing.

“So, the sorts of assets we’d look for in a recessionary environment would be something like gold. This asset performs well when you get falling economic growth and inflation. We would also look at cash and TIPS.”

Another structural driver that we find interesting is energy transition. There’s been a lot of discussion about solar and wind being the cheapest forms of energy, but the requirements for extra grid capacity and storage might make this ‘green energy’ inflationary

Cameron Gleeson

Long-term structural drivers

In the current environment, one of the long-term structural drivers Atrium is focused on in its portfolios is artificial intelligence (AI). Glen believes AI can broadly be put in the category of productivity improvement, which is deflationary.

“AI will help to offset a shortfall in the labour force, which has peaked globally and is falling. So, with the supply of labour falling, the cost of labour is increasing. That’s why AI needs to be successful to counter that trend.”

However, he acknowledges that Australia’s high immigration targets will help to offset any potential shortfall in the local labour market.

Cameron agrees there is a global constraint on labour supply. Therefore, the ability for AI robots and collaborative robots (cobots) — cobots possess the innate ability to work in tandem with humans, whereas traditional industrial robots work in place of humans — can help with labour shortages by doing some of the jobs of humans. He says across the Western world, services will be increasingly impacted by AI, which will be deflationary.

“Another structural driver that we find interesting is energy transition. There’s been a lot of discussion about solar and wind being the cheapest forms of energy, but the requirements for extra grid capacity and storage might make this ‘green energy’ inflationary,” says Cameron.

According to Cameron, the best case scenario in Australia in terms of net additional funding for energy transition over the next 50 years is about $225 billion. However, because inflation doesn’t play out over 50 years, Betashares instead looks at its portfolios on a much shorter five-year basis. By doing so, it is able to adjust for changes in the economy and Government policy, which will inevitably occur, as we transition to ‘green energy’.

“So, while it’s always interesting to look at where structural inflation will play out over the long-term, what markets respond to is the next five years. This means the inputs to our models are based on that five-year window,” says Cameron.  

About

Glen Foster is Head of Risk, Senior Portfolio Manager at Atrium Investment Management; and

Cameron Gleeson is Senior Investment Strategist at Betashares.

They spoke on ‘Achieving real portfolio returns in inflationary times’ at the 2024 IMAP Portfolio Management Conference in Melbourne.

The session was moderated by Robbie Lew — Manager, Multi-Asset at Lonsec.

 

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