The return of bonds as a viable alternative to equities adds another layer of complexity for investors looking to tweak their portfolios.

High inflation is proving hard to shake off, and fund managers say that means investors need to look for businesses with pricing power and think twice about those laden with debt.

The Reserve Bank of Australia said on Wednesday that it would “do what is necessary” to return inflation, at 5.6 per cent for the year to May,to its target band of 2 to 3 per cent.

Meanwhile, rising interest rates have pushed the three-year bond rate to 4.2 per cent, equivalent to the nominal dividend yield on the benchmark S&P/ASX 200 Index for the first time since 2011.

The return of fixed-income as a viable alternative to equities adds another layer of complexity for investors wondering how to position their portfolios for prolonged higher inflation.

Where inflation will go next is a question central banks and economists have struggled to answer for the better part of 19 months, Prime Value chief investment officer ST Wong says.


Maple-Brown Abbott head of Australian value equities Dougal Maple-Brown agrees: “This tightening cycle has been quicker and tighter than any previous cycle in Australian modern monetary history, so we’re in uncharted waters.

The macro is particularly hard to call. Will it be a really nasty recession like in 1992 when I got my first job? Possibly. Will it be a mild recession? Are central banks around the world going to engineer a wonderful, soft landing? I think it’s really hard.

“Anyone who’s confident about it, I’d just discount immediately.”

So, what does it mean for investors? According to Wong, there are a few fundamentals investors can use to find the opportunities and avoid the soft spots in a world of stickier inflation.

What to look for

His first step in periods of higher inflation is to seek companies with strong balance sheets.

“High inflation means the cost of debt will be higher, so I want to avoid companies that could be saddled with the rising cost of debt.”

He also suggests investors take care with companies that have heavy capital investments, but keep an eye out for those with “positive industry structures” such as monopolies or duopolies.

“Good industry structures help. In real life, the likes of, Domain, they’ve been able to increase prices because of the dual player function,” Wong says.

A second opportunity for investors lies in companies that benefit from higher inflation.

“Think about your car insurance – you’re probably paying about 25 per cent more for your insurance than you were last year, and the funny thing is, the premiums never go backwards,” he says.

A third opportunity lies in companies oversold or affected in the near term by cyclical demand coming off, such as JB HiFi, that may look better in two or three years.

“Sure, sales are soft at the minute. But the balance sheet is strong, it’s got no inventory issues, I think companies like that should emerge stronger.”

Maple-Brown agrees insurers could present opportunities to protect against inflation, but adds that historically, commodities have also offered a reasonable hedge.

But investors need to be aware of the nuances.

“While we like them, you’ve also got to be conscious of where the commodity prices are trading versus long-term prices.

“Let’s take iron ore at $110 a tonne, it’s trading well over what most people – myself included – think is a long-term sustainable price. So while we think commodities are a reasonable place to be, you’ve got to keep your eye on where they’re actually trading from a valuation standpoint.”

He says that more broadly, Maple-Brown Abbott is overweight on energy and insurers.

Think twice about yield plays such as property trusts, Maple-Brown says.

“They pay a distribution, and when rates were zero, that 4 or 5 per cent yield was pretty attractive. Now that rates have moved up to 4 or 5 per cent, that’s less attractive, so maybe the market has priced that in.”

Premium-rated growth stocks also need closer examination, with Maple-Brown citing CSL, which has a valuation he has been “quibbling with” for a while.

“When interest rates bottomed a couple of years ago, CSL’s price to earnings ratio peaked at around 45 times forward earnings,” he says.

“Today, on consensus numbers, CSL is still trading at around 30 times one-year forward earnings, and of course the long-bond and the cash rate are roughly 4 per cent.

“The other thing about those stocks is that everybody loves them because they’re defensive. CSL’s blood plasma should be a defensive industry, but it doesn’t necessarily make it a defensive stock because it depends on what you pay for it.”

Where central banks go next will have the biggest ramifications for the banks, Maple-Brown says.

The “negative story” is that they’re dealing with the RBA’s tightening cycle, amid surging levels of household debt. “But on the positive story, you can point to unemployment which is less than 4 per cent … and you can ask how bad will it be if unemployment goes from 4 to 5 per cent? That’s not a car crash.”

SG Hiscock portfolio manager Hamish Tadgell echoes Wong and Maple-Brown’s preference for insurers, adding that he is also carefully watching the banks.

He says Australia’s banks have done “reasonably well” over the past 12-18 months, but it’s getting more challenging, making insurers more attractive.

In times of uncertainty, he says investors need to be careful about being “too definitive” in their views.

“By the fact that things are uncertain, it makes it really difficult to navigate,” he says. “You don’t want to be overly prescriptive in this type of environment.

“You want to really look at what has happened in the past and try to draw inference from that, but again, you’ve got to be careful of over-forecasting.”

The difficulty in predicting inflation over the past 18 months highlights the importance of a disciplined process and a diversified portfolio, Tadgell adds.

Infrastructure as a hedge

4D Infrastructure principal Sarah Shaw says infrastructure is a “core place to be” in an inflationary environment, particularly if investors are looking to capture the valuation upside.

“Within the infrastructure space, you have two very distinct asset classes,” Shaw explains.

Toll roads, airports and rail companies are considered “user-pay” companies, and she says they are “fantastic” for capitalising on the inflationary environment, as they generally offer an inflation hedge.

“They’re not only capturing the consumption that we continue to see, for example with airports, but there’s an explicit inflation hedge and the beauty of that is if it gets compounded.

“If you’ve got a couple of years of higher inflation, but you’ve got a 20, 30, 40-year asset, you’re compounding that inflation to future returns.”

On the other hand, nominal-rate utilities that don’t receive interest rate adjustment until it is approved by the regulator can struggle in these periods.

“They are the utilities that don’t have an inflation pass-through – they are going to suffer in this environment, where inflation is being passed through to cost but not into top lines.”

Competition from fixed income

Tadgell notes that another key trend is the return of fixed income as a viable alternative to equities, adding this is another variable that investors need to consider.

“Twelve months ago there was no alternative. Fixed income in some parts of the market was negative. Today, you can get 5 per cent, so you can get at least some positive diversification in the portfolio through broader asset diversification.”

Schroders’ Australian fixed-income head Stuart Dear agrees inflation is likely to stay higher than the past couple of decades, but that can be a good thing for fixed income.

He says that if inflation stays higher, pushing central banks to keep interest rates higher, then bond yields also tend to stay elevated.

However, he says investors still need to think about finding more explicit inflation protection in their fixed-income portfolios. This could include inflation-linked bonds (floating-rate notes) that pay interest based on the level of the cash rate rather than a fixed rate.

Another option is seeking better sectoral exposure to counter inflation.

“In the corporate space, you can own utilities which have in their business models CPI-linked revenues. You can do all of those types of things within your fixed-income portfolio to give you a bit more fixed-income protection,” he says.

“The other way we probably need to think a little differently about fixed income is around correlations with equities. Diversified portfolios have done very well over the last few decades because it had that negative correlation between bonds and equities.

“We think that if inflation stays higher, that [correlation] breaks down a little, and we’re more likely to see correlations swinging between positive in the up-cycle back to negative in the down-cycle.”

Keep to your course

Vanguard Australia’s head of personal investor Balaji Gopal says the key for investors is to stick to their goals, be disciplined and remember their time horizon.

He says the ability to put money away and save and invest will have a much bigger impact on their future wealth than market fluctuations.

“We’ve done some research looking from 1994 to 2008. These include periods when we went from a high-interest environment to a more normal environment. Annualised performance following rate hikes have largely worked themselves out and normalised over the long term,” Gopal says.

The accompanying graphics outline inflation since 1948, as well as how equities outperform bonds and cash over the long term. A dollar invested in Australian shares in 1900 would now be worth almost $800,000, compared to just under $900 if invested in Australian bonds and about $250 if invested in cash.

“So again, the message consistently is that irrespective of your levels of wealth, if you have your goals clearly defined, and you continue investing, your longer time horizon will help you iron out all the shorter-term noise.

“A high-interest rate cycle, a low-interest rate cycle, geopolitical issues – they all wash out in the long run.”

Source: AFR

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