Portfolio management in an inflationary environment

By Jayson Forrest - Managing Editor  - IMAP Perspectives

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How do portfolio managers and advisers transition portfolios to a higher interest rate environment? Brad Matthews (Brad Matthews Investment Strategies), Brendan Paul (Atrium Investment Management), and David Cohen (Evergreen Consultants) discuss the implications of inflation and interest rate rises on portfolios.

With both central banks and inflation on a path towards normalisation, Brad Matthews - Founding Director at Brad Matthews Investment Strategies - believes inflation in Australia will hit 2.5 per cent, the cash rate 4.4 per cent, and the 10-year bond rate at 4.1 per cent over the next 2-3 years. And while he agrees it make take some time for Australia to get to these levels, the key point to remember, he says, is that central banks around the world are on a path to normalisation.

“And that’s partly because inflation is also on a path to normalisation,” he says. “Some of the deflationary forces that have been so dominant over the past couple of decades have probably run their course, so I do believe we will see inflation settle back to a long-term average in that 2-3 per cent range, which is the target of the RBA.”

The reason Brad believes this normalisation process is happening is because central banks realise they can’t maintain QE programs and running negative real interest rates for the long-term any longer. And that’s because negative real interest rates have a number of undesirable consequences, including:

  • discouraging productive investment;
  • reducing housing affordability;
  • creating wealth inequality; and
  • being ineffective at stimulating spending.

Against this backdrop with the likelihood of a number of interest rates rises this year and into next, Brad believes the private sector is “reasonably well positioned” to deal with these higher interest rates. And while he doesn’t expect interest rates to increase dramatically, he says there is enough buffer in Australian household budgets and spending to absorb any interest rate increases.

“I don’t believe any increase in interest rates will be the cause of a recession or will be a major detractor to company earnings growth. So, I don’t think this scenario is bad news for equities, for example.”

Brad Matthews, Founding Director at Brad Matthews Investment Strategies.
Brad Matthews - Brad Matthews Investment Strategies.
Brendan Paul is a Senior Portfolio Manager at Atrium Investment Management
Brendan Paul - Atrium Investment Management
David Cohen is Head of Research at Evergreen Consultants
David Cohen - Evergreen Consultants

When you invest in growth assets, you do get protection from inflation, as company earnings tend to grow in line with inflation. Real assets also grow in line with inflation. So, if you are looking to protect against inflation, you shouldn’t be selling out of growth assets. The real economy can absorb the higher interest rates, so there shouldn’t be too much damage to longer term company earnings

Brad Matthews

Portfolio implications

While sidestepping a recession, Brad believes there are implications of rising interest rates and inflation on portfolios, which he says can be grouped into three parts:

1. Growth assets will ultimately protect value;

2. Progressively lean into duration as real interest rates increase; and

3. Gold could have a tactical role to play. 

1. Growth assets

“I think growth assets will ultimately come through this period okay. We have recently seen a spike in volatility and equity markets don’t like unexpected increases in interest rates. But ultimately, when you invest in growth assets, you do get protection from inflation, as company earnings tend to grow in line with inflation. Real assets also grow in line with inflation. So, if you are looking to protect against inflation, you shouldn’t be selling out of growth assets. The real economy can absorb the higher interest rates, so there shouldn’t be too much damage to longer term company earnings.”

In terms of asset bias in portfolios, Brad believes Australian equities are well-positioned compared to global equities to deal with rising interest rates and inflation, due to Australia’s commodity exports and its more constrained inflation situation.

“If you combine these factors with the RBA’s more dovish monetary policy, it lowers the risk that inflation and interest rates are going to be a major drag on markets here,” says Brad.

He adds that property and infrastructure (both listed and unlisted) are also still relatively well-placed, because the anticipated interest rate increase will not be substantial and only slightly above the inflation rate. By having a healthy allocation to property and infrastructure, Brad believes investors can reduce their exposure to volatility or economic downturns that may be associated with rising interest rates.   

2. Duration

In terms of fixed interest, as the current level of interest rates are below where the market sees the longer term level, Brad doesn’t think it’s a particularly good time to have long duration assets.

“Although, it should be noted those yields have come up reasonably significantly over the past six months. So, it is starting to look a little bit more attractive and as rates lift, from a portfolio perspective, we think about leaning into duration and gradually accumulating it. We’re not going to be able to pick the peak, so taking a dollar-cost-averaging approach to that makes a lot of sense.”

3. Gold

Another asset talked about at times of rising interest rates and inflation is gold. Brad believes gold can play a tactical role in portfolios, although he concedes gold becomes more questionable from a long-term strategic allocation position.

“Certainly, if there are periods where the speed of interest rate increases doesn’t keep pace with inflation, then that could be a good time to hold gold, where you have persistence of negative real interest rates.” 

And what about cash? Given the current environment, does it have a role in a portfolio?

Brad says he would still keep cash at a minimum, due to the fact it has been artificially held low by policy and “when you start to see some of those shorter duration yields available in the 2-3 per cent range, it’s hard to create a scenario where cash actually does better”.

“So, I would only hold cash for transactional purposes. I really don’t believe it can play much of a role in an optimised portfolio at this point in time.”

However, he adds once the market returns to a normalised environment, where investors can get a fairer return from cash, then he believes cash is better positioned to come back as a strategic asset in a portfolio.

At Atrium, the way in which we use trend following strategies is to look through into the underlying trend and understand what the duration is of that trend. Currently, our portfolio is about four to six weeks, which is about the average speed of the trend following we have

Brendan Paul

The portfolio construction challenge

Brendan Paul - Senior Portfolio Manager at Atrium Investment Management - agrees that constructing a multi-asset portfolio in the face of rising interest rates and inflation will be challenging for portfolio managers and advisers.

Brendan believes the current environment is one where macro-economic volatility will rise to levels the market hasn’t seen for a number of decades. Along with inflation, he adds we’re already seeing volatility increasing dramatically, which is reflected in higher yields. However, Atrium expects this could be an environment where that continues for a lot longer than many people anticipate.

“And that has important implications,” Brendan says. “We think that means a rise in risk premiums - both on the bond yield curve and in equity risk premiums. That will impact asset correlations.

“We have been though an environment where a 60/40 portfolio has performed very well for investors and advisers. That period was characterised by low and negative bond/equity correlations, which meant that the bond component of investors’ portfolios did a wonderful job as a diversifier. But we think we’re now on the cusp of a very different environment, due to rising inflation.”

Atrium is seeking to address this new environment through a risk-targeted approach, where it looks for genuine diversification by investing in asset classes and strategies that it believes are truly uncorrelated, and where it has high confidence that they will remain uncorrelated. It believes this approach will help deliver a smoother investment journey for clients, while maximising return opportunities.

Certainly, with high yielding credit, the correlation with equities would suggest that if we end up in a high and rising inflationary environment for a number of years, credit would suffer through its risk correlation. So, you want to have low duration in your credit exposure

Brendan Paul

Trend following strategies

As part of its approach to asset allocation, Atrium uses trend following strategies. This systematic strategy is a trading style that attempts to capture gains through the analysis of an asset’s momentum in a particular direction. But how long does an asset need to trend in a specific direction for it to become investable under a trend following strategy?

“It’s a good question,” says Brendan. “Trend following strategies are something we give a lot of thought to. You can find trend following strategies that are very fast, and others that are slower moving. At Atrium, the way in which we use trend following strategies is to look through into the underlying trend and understand what the duration is of that trend. Currently, our portfolio is about four to six weeks, which is about the average speed of the trend following we have.

“However, it really comes down to how complementary that is to the rest of your asset allocation process. We have some tactical elements in our asset allocation process, and at the end of the day, it’s all about using strategies that are going to deliver returns that are uncorrelated with bonds and general equity markets.”

I think it’s a dangerous time to have passive management in emerging markets because there will be some economies that really struggle in this environment, particularly those that are commodity importers. At the best of times, emerging economies are vulnerable to trade imbalance, so this environment really magnifies the potential issues in these markets.”

Brad Matthews

The role of credit

In an environment where nominal yields are rising, Brendan also believes credit still has a role to play in portfolios. However, he qualifies this by adding that when talking credit, it does depend on whether its investment-grade or high yield.

“Certainly, with high yielding credit, the correlation with equities would suggest that if we end up in a high and rising inflationary environment for a number of years, credit would suffer through its risk correlation. So, you want to have low duration in your credit exposure.

“So, be selective, and be careful about duration that comes with credit. Don’t take on more duration than you’re comfortable with in the portfolio, given that nominal yields can continue to rise.”

Ukraine and emerging markets

While conflict in Ukraine continues unabated, what does this conflict mean for emerging markets in this high inflation and interest rate environment?

For Brad, this uncertainty highlights the need for active management.

“I think it’s a dangerous time to have passive management in emerging markets because there will be some economies that really struggle in this environment, particularly those that are commodity importers. At the best of times, emerging economies are vulnerable to trade imbalance, so this environment really magnifies the potential issues in these markets,” Brad says.

However, on the flip side, he believes there are commodity exporters among emerging economies that will do well under these conditions, with increased commodity prices and demand, as developed nations seek to diversify their sources of commodities.

“Valuations on the whole look really attractive, and while I wouldn’t sell out of emerging markets, I’d still be cautious, particularly in China.” Brad says. “You need to be careful with assessing the governance and regulatory risk in China. However, this risk can be managed by having an active manager on the ground in the market.”  

About

Brad Matthews is Founding Director at Brad Matthews Investment Strategies; and Brendan Paul is a Senior Portfolio Manager at Atrium Investment Management.

They spoke at an IMAP Specialist Webinar on the ‘Implications of interest rate rises’, which was moderated by David Cohen, Head of Research at Evergreen Consultants

The webinar video can be viewed on IMAP's channel HERE

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