RANDS AND SENSE
By Carolyn Levin
Inflation has dominated the headlines this year – a global problem amplified by Russia’s war in Ukraine, at a time when supply chains disrupted by Covid-19 were just beginning to normalise. However, the tide appears to be turning. As commodity prices plummet from their all-time highs, there are tentative signs that inflation may be peaking in the US, with South Africa expected to follow suit. Nonetheless, the global environment remains volatile, and elevated inflation levels are likely to continue for some time.
What does extended inflation mean for investors’ portfolios for the rest of 2022? During periods of potential changing market regimes, it is vital to look beyond those assets that have performed well over the past decade, as ultimately, the assets that will perform best going forward will be determined by what causes the markets to turn.
If central banks manage to get inflation under control, albeit at a higher level, without forcing the global economy into a severe recession – the so-called “soft landing” – investments that are already highly cash generative with lower leverage are likely to do better.
If, however, central bank tightening ultimately pushes the global economy into a severe recession – the so-called “hard landing” – this may in turn require significant monetary easing, resulting in markets again paying a premium for high growth assets, with the potential to produce significant cash flows in the future. It is even more important for investors to “spread their bets” at these times and not be “all-in” on only one potential economic outcome.
Equities: quality should outperform
Equities are typically considered the best hedge against inflation as they are ‘real’ assets which represent a claim on future cash flows. Businesses with strong pricing power can pass on higher costs to their consumers, therefore in theory, quality companies should outperform in times of inflation. However, history has shown us this relationship does not always hold, as rising inflation causes the discount rate on future equity earnings to rise, resulting in a lower present value of those cash flows.
While this can be bad for all parts of the equity market, it can be particularly pronounced in higher growth areas, as we have already seen last year and this year to date. However, over the long term, if one can ride out the inflation-induced volatility, we believe equities remain the best asset class for generating real returns and preserving portfolios.
Fixed income: add back duration
During inflationary periods, fixed income investments are more vulnerable because of the potential for interest rates to rise, which could cause prices for existing bonds to fall. While we remain underweight in both the asset class and duration, following the most recent interest rate hikes, we have started to add back duration to our portfolios.
Commodities: reversed upward trend
Providing good protection against inflation, commodities can be difficult to implement due to the cost of carry and negative roll yield. While broad commodities have performed well year to date, this is after years of underperformance. Should the Russia/Ukraine conflict continue in the medium term, paired with ongoing supply chain issues, then commodities could continue to be well supported in this environment.
Gold: a valuable diversifier
Gold typically performs well during periods of market stress, as well as rising inflation expectations, as it has proven to be a valuable diversifier in recent months. As interest rates rise, so too does the opportunity cost of holding gold. However, given all the current macro uncertainty, investors can feel comfortable holding a small gold position as a diversifier in portfolios.
Domestic or offshore?
The South African market remains undervalued, and we currently see several good investment opportunities. However, with numerous structural challenges, we would not advocate bringing already externalised money back into the country.
Furthermore, the inflationary environment has not changed our view that investors should invest their surplus assets offshore and retain locally only what is required to fund their lifestyle. At Stonehage Fleming Investment Management, we believe in multi-asset portfolios, tilted towards equity but dependent on an investor’s needs and risk tolerance. It is critical that in periods of heightened uncertainty and volatility, investors stick to their long-term objectives and do not make rash changes to their investment strategy.
Carolyn Levin is a director at Stonehage Fleming Investment Management South Africa