Prepare for reflation. Yes, you read that right.
It’s difficult to imagine now, but there was a time when double-digit inflation gripped the world. Major blame was assigned to the 1973 oil shock for injecting inflation into the economic bloodstream. However, it wasn’t the sole culprit. Economists also identify easy monetary policies from central banks to support governments’ deficit spending as an important contributor.
In 1980, following years of rising prices with the Consumer Price Index (CPI) hitting a now unfathomable 15%, the US Federal Reserve, led by Chairman Paul Volcker, aggressively fought back by increasing the prime cash rate to 20% by the middle of 1981. Doing so effectively broke the back of US inflation.
Volker’s success became the model for central bankers globally, setting in train a trend amongst central banks to manage their economies to inflation targets. Any time inflation was even looking like getting up, central banks would increase interest rates to stomp on it.
In the decades that followed, investors, economists and policymakers have continued to look out for hints of resurgent inflation. But as data has shown, inflation has become ‘the dog that didn’t bark’.
Deflation trend ending?
Having kept inflation in the cellar for so long, central banks have, since the GFC, unsuccessfully tried to lift the inflation pulse with ultra-low interest rates and quantitative easing.1 Despite their best efforts, undershoots of inflation targets have become common place. Now, though, there are reasons to think that the deflationary trend may be weakening, or even ending.
The supply of low-cost emerging markets’ labour has been a key driver of lower wages and prices. There’s been an about-turn in recent years as wages have been rising in these countries, particularly in Asia. The pandemic has also highlighted many companies’ and countries’ vulnerability to global supply chains.
In response, companies are now looking to bring production closer to home, including on-shoring. Governments are under pressure to ensure security of supply of essentials, such as medical equipment and pharmaceuticals. In other words, we may be transitioning from lowest-cost, ‘just in time’ production to relatively higher-cost, ‘just in case’ production. This type of de-globalisation will result in higher wages and prices.
Use inflation to deal with government debt
Countering the economic impact of the COVID-19 pandemic with much-needed support programs has greatly increased government debt and this is raising worry about passing massive liabilities to future generations and crimping their living standards. Still, governments are going to have to remain spenders of first resort until normal social and economic life returns.
How to manage ballooning public debt is occupying policy makers’ minds. One solution is to inflate the debt away. If governments can keep inflation higher than interest rates, then all else being equal the ‘inflated’ taxation revenue pays down the debt faster, essentially inflating the debt away.
All of this adds to our view that global economic trends coupled with the evolution of government and central bank policy towards reflation makes it highly unlikely that real interest rates can rise meaningfully from here. To be clear, ‘higher inflation’ doesn’t have to mean horrendous 1970s type inflation, just inflation that’s above current unusually low expectations.
With the above in mind, we are increasingly seeking exposure to a diverse set of assets that offer some degree of inflation protection at a reasonable cost. Gold has a strong relationship to inflation, but is expensive to own outright, at least relative to its own history.
While an elevated gold price does not preclude us from owning the precious metal, it does force us to hedge against a falling gold price. The portfolios have accrued meaningful gains from holding gold over the past several years. By protecting the portfolios from losses while the gold price remains elevated we’re able to preserve profits the portfolios have already made, while maintaining exposure to further upward price movements.
While gold can be an expensive inflation hedge, cyclical stocks that rely heavily on economic growth and commodities currently offer cheaper ways of benefiting the portfolios from a reflation scenario. We are very mindful of the potential downside for cyclicals and as such are researching efficient ways of marrying downside protection to strategies that we think fit a ‘participate and protect’ approach. Emerging markets and miners are examples of sectors where this type of approach makes sense, and we continue to research other investments with similar properties. Chinese government debt is another area that we believe helps the strategies at this point, particularly from interest rate advantage and currency viewpoints.
There were no major changes to the MLC Horizon and Index Plus portfolios’ positioning during the September 2020 quarter.
On the other hand, there was activity in the Inflation Plus portfolios, which MLC Horizon inherits through Inflation Plus, and MLC Index Plus portfolios through the real return strategy, which is managed similarly to Inflation Plus.
The changes to the MLC Inflation Plus portfolios included:
- Adding a ‘participate and protect’ exposure to emerging market shares allowing the portfolio to participate in the first 15% of market rises while limiting capital losses.
- We took advantage of the strong gold price to take profits and restructure downside protection.
- Established a position in Chinese government debt with exposure to the Chinese yuan. The bonds are a source of higher interest rates, and the yuan exposure helps diversify the currency composition of Inflation Plus.
In summary, a prudent approach to building inflation hedges into our multi-asset portfolios is well warranted at this point in time, but attention must be paid to the consequence of further bouts of disinflation or deflation. Rather than betting on reflation by simply buying expensive assets that are linked to inflation and hoping we’re right, at MLC we prefer to invest time to identify exposures that are likely to react positively to a reflationary environment but are not as sensitive to a continuation of what is now a very long period of falling and low inflation rates. This obviously brings with it a series of trade-offs that limit the reward of being ‘right’, but at the same time reduce the consequence of being wrong. Given that it’s impossible to have perfect foresight, and that we are ultimately risk managers not gamblers, we believe this is the right way to invest in these highly unusual times.
More information on each portfolio’s positioning is available in the fund commentaries available on the Fund Profile Tool on https://www.mlc.com.au/fundprofiletool.
1 Quantitative easing, or QE as it’s better known, is a policy in which central banks like the Reserve Bank of Australia, the US Federal Reserve, and the Bank of England, buy financial assets, such as government bonds from the open market to encourage lending and investment.
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