RANDS AND SENSE
By Anet Ahern
For the better part of a decade developed markets have experienced low and contained inflation rates, while local inflation rates have been substantially higher. However, due to unprecedented levels of stimulus coupled with supply pressures following the Covid-19 pandemic, the world may be in for a reversal of this trend.
Newspapers are filled with headlines discussing rising inflation and whether it is a transient or sustained phenomenon. What is discussed less often is how resultant shifting dynamics in asset classes impact the way we construct portfolios.
If investment managers fail to accurately anticipate the implications of the shifts under way, there is a real risk that their ability to help clients build wealth in the long-term will be undermined. In such a perilous environment, the value of differentiated thinking can really shine through.
Inflation in the US has averaged roughly 4% since the 1970s. Since the Global Financial Crisis, and despite high levels of stimulus, inflation has continued to trend at low levels. However, Covid-19 brought about more stimulus, at a time when many had expected rates to normalise. Perhaps this round of monetary largesse was the final straw for a rebalancing that was already long overdue. Regardless, it is possible that we are on the brink of a sea-change that will upend the investment status quo.
Winners and losers
The truth is that an “abnormal” investment environment if maintained for an extended period of time, can shape investment behaviour. Low inflation and low-interest rates have rewarded some assets at the expense of others. Winners have included the mega-cap technology and growth stocks, while value and emerging market stocks fell out of favour, leading to a sharp divergence in markets.
Such an environment has a dangerous side effect. If the recipe for success is agreed and known upfront, it is easy to become complacent and stop doing time-consuming and expensive research. (Cue the rise of passive investing.) The same thinking applies to portfolio construction – why deviate from a formula that has worked for the past few decades?
The answer is that the next decade is likely to look very different from the previous four. South African income investors have been in the sweet spot for the last few years, earning (relatively) high real returns from the short end of the fixed income market, without assuming too much risk.
Covid-19 led to decisive action by the SARB and ultimately the removal of inflation-beating returns from the short-end of the fixed income market.
Investors with a lower risk appetite, who want to generate acceptable returns, now need to consider other investment options. For example, there are opportunities at the longer end of the yield curve. However, bonds alone may not be enough.
Traditionally, property has been the go-to asset class for conservative and income investors, as rentals have historically offered inflation protection. However, the past is not a proxy for the future.
Making the right selection
The property sector has been burdened by high debt levels, and, with depressed rentals, the prospects for capital and income growth from this asset class seem limited, while risks remain elevated.
From an investor’s perspective, thorough analysis and selectivity are therefore required, rather than simply allocating money to the asset class. Similarly, selected equities, while historically touted as the riskier asset class, may deserve a larger allocation in a portfolio to bolster returns.
As always, the price paid for an asset is key. Some pockets of the equity market are very expensive. However, due to the bifurcation in the market, there are also opportunities available at very attractive valuations. A number of these are in the very sectors that have suffered over the past few years, and that are well-poised for a reversal in the current inflation (and market) environment.
The investment world has changed substantially. Investors who rely only on the tried and trusted recipes of the past, run the risk of not only not meeting their long-term investment objectives, but missing out on what we believe to be rarely-seen opportunities.
Anet Ahern is chief executive at PSG Asset Management.