By David Crosoer and Professor Prieur du Plessis
Imagine driving on a straight road and then being surprised by a corner. Initially, perhaps, one isn’t too concerned, as the expectation is that it’s just a mild bend in the road. But as the corner gets bigger, there comes a point where a decision needs to be made as to whether to maintain speed, slow down, or even try to accelerate out of it.
We may think that the speed at which your investment portfolio is travelling is the number of equities you are holding in your portfolio, and persistent inflation is the unexpected corner in the road. While many of us may have come into this corner uncomfortably fast (after all, the road has been straight for much of the past decade) we don’t necessarily need to brake if the corner is not too sharp, while any hasty adjustments to the steering wheel might take us off the road.
As things stand today, consensus is that the corner will be okay. According to the market, the US Federal Reserve won’t hike interest rates much past 3.5 percent, which is significantly less than how it has responded in the past to comparable higher inflation. At the same time, participants argue that global inflation may have peaked already, and while central banks are still expected to raise rates multiple times in the next 12 months, they could be cutting towards the end of next year.
The challenge to this view is that the current environment remains highly uncertain, and it’s hard to see clearly where inflation is going. This is especially true because it has been difficult for global supply chains to respond with increased supply to higher prices, given their dependence on Russian and Chinese economies (and the intent from many Western companies to diversify away from both), as well as the complexity of decarbonising the supply chain more generally.
Consequently, there are non-negligible grounds for expecting that inflation may be higher for much longer than anticipated, and central banks could be forced to respond with very aggressive interest rate hikes, so that even equities with some pricing power in an inflationary environment will come under significant pressure.
By way of an analogy, just like investors were surprised post-2008 with how low interest rates remained for much longer than expected, so today the converse may be true as interest rates remain higher for much longer than expected.
As an investor, what then should one do? Those who slowed down well before the corner need to decide whether it is now safe to speed up. Unsurprisingly, most of these investors have remained defensively positioned for the time being. Equally unsurprisingly, of course, the more aggressive drivers have already decided to slam their foot on the accelerator, given their assessment that we are already far enough into the corner to speed up.
On the other hand, investors who feel they have come in quite fast will have a sense of how their portfolio behaved over the past six months, and whether they need to make small adjustments to improve their handling, or large adjustments to reduce the maximum speed of their vehicle.
Small adjustments may include a bit more cash in the tyres of the portfolio or rearranging the suitcases so a particular bag on the roof (or manager style in the portfolio) doesn’t cause the car to sway precariously.
In contrast, large adjustments would be ensuring your portfolio can only go a certain maximum speed, if you inadvertently constructed or climbed into an investment portfolio that can go faster than you are comfortable with.
As a multi-manager, we try to drive smoothly around corners, and try to avoid having to change our speed frequently. We carefully consider the speed each portfolio is expected to go and try to keep to a driving style that allows the managers we select to deliver most of the outperformance.
We do this by ensuring that we are driving a carefully diversified portfolio and keeping our eyes on the road. In the long run, we think this is the best way to get our passengers safely to their destination.
David Crosoer and Professor Prieur du Plessis are chief investment officer of PPS Investments and chair of the PPS Multi-Managers Investment Committee, respectively; email: [email protected]
BUSINESS REPORT