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22.03.2016

Giselle Roux: Why inflation matters in a balanced portfolio

Until mid-2015, investors in global equities had experienced decent returns. This is without the currency move, which is unrelated to the fundamental performance of the market. Exchange rates inevitably influence the attitudes of investors to regions, if they are unhedged. Consider a US-based entity. The strength of the USD in 2015 made most other markets unattractive.

Where investors could find easy access to hedged options, they could then take a view on those markets, but in some cases, particularly emerging markets, the hedging decision is complex and costly. Unsurprisingly, there have been large outflows in emerging markets from US investors, regardless of the merits of some countries and stocks. Whether we like it or not, these flows can determine returns rather than a view from our shores.

That leads to the influence of factors outside of stock fundamentals. Typically this is referred to as top down versus bottom up. Top down accounts for economic drivers such as inflation, interest rates, investment spending and government policies. Bottom up takes the argument away from these, towards companies that may be largely immune from economic dynamics but still service needs.

An extreme example is funeral services, an unavoidable product regardless of inflation or interest rates. Food consumption, utilities and healthcare are also considered to be relatively impervious to economic growth outside of exceptional circumstances. These days, many believe some companies in the IT sector are unlikely to be affected by gyrations in GDP growth, as consumer behaviour rapidly adapts to their services.

Broader outlook

Aside from a few examples, it is far-fetched to believe economic and societal trends don't have a major impact on a company's growth potential and valuation. Healthcare is probably the best illustration. 

Individual companies aim to service specific requirements ranging across a wide range of health conditions. Cures for cancer are unrelated to economic factors. Yet the regulatory environment, government intervention and cost imposts can overwhelm the outcome for the company.

Apply that to the topic du jour of inflation or deflation. Of course, there are many other substantial issues, yet right now central banks are fixated on preventing an unattractive disinflationary symptom from gaining ground. The first step would be to consider what could take inflation higher, or rather inflation expectations, and then the consequences for equity markets.

The US is most likely to experience a rise in inflation for three main reasons. Firstly, labour costs will probably edge upwards. Some states and organisations have lifted their minimum wages and there is a shortage of skills in a number of industries. 

The second is the argument that the oil price will increase towards the end of the year as US production tempers, with new output uneconomic. This rests on the proposition that as the cost of new US oil wells is above the current price, there will be little increase and possibly a decline in output. Finally, healthcare and rental costs, a relatively large part of the US CPI, are already on the move. 

A combination of these factors could see inflation move above the low rate financial markets are currently assuming. This is not to suggest a period of high inflation (4 to 5 per cent), by recent standards, is probable but rather that it will be above expectations.

Consider all options

One can argue it would be remiss not to include this prospect in a portfolio. And that may have a major impact on returns relative to the index. Bottom-up investment funds are shy of energy exposure, as the predictability of returns is low and largely distinct from the company's management skills. Yet a sharp rally in energy stocks may leave such a manager lagging the index. Others may decide to hedge their bets and include an oil services company, for example. This would provide some leverage, while limiting downside if it does not eventuate.

Top-down investors, however, may contemplate a wider set of implications. Companies with low pricing power will find it harder to pass on the costs. Household income will rise with higher wages and householders will spend more; conversely, corporations with high labour cost ratios may take time to adapt. Companies that can reduce wage costs through automation may benefit. Regions with lower wage costs may get incremental investment. Interest rates may rise more than expected.

Keynes famously stated: "When the facts change, I change my mind." If economic influences are in flux, it pays to be a bit sceptical of reliance on a bottom-up approach to a global portfolio. By the same token, the trends are not certain and castigating a fund manager for taking a view that did not come about, if well argued, seems mean. 

Then there is the case for deflation – excess capacity in many industries, low demand due to demographics, high debt and disintermediation of prices through digital adaption. These should not be ignored, but may not stand in the way of a tick up in inflation, at least in the short term.

One advantage of talking to fund managers is to ask them what the companies they visit are experiencing, what changes they are adapting to and where their concerns lie. Those that fall back on company specifics without regard for the broader issues are less convincing than those that express their uncertainty. These, in turn, are much more likely to react when circumstances change than cling to a formulaic model.

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