In an interview with ausbiz, Paul Ashworth, our Chief Investment Officer, outlined his thoughts on inflation risk and implications for equity and bond investors. Should investors be be worried about inflation risk and the flow on to asset markets?
Cameron Harrison has been of the strategic view for the last few years that monetary policy had largely run its policy course, particularly in terms of stimulating economic growth and supporting employment. It, of course, retains its dampening powers to raise rates.
Crisis, and in this instance COVID, has served as a necessary catalyst for fiscal policy to finally step-up to the plate. COVID is the quickening event of what was an inevitability for fiscal policy’s increased role. So, the increased role and relevance of fiscal policy is a big deal; the US Governments USD $1.8 trillion stimulus package underscore this. It marks a potential turning point for bond and equity markets, which are getting somewhat 'lathered-up' as the ‘punch bowl’ that has been falling bond yields, is now empty.
So YES, what is occurring is important. Does it portend a period of significant upward inflation, and more importantly inflationary expectations? We are not wholly convinced. However, we do think the 30-year easy road for bonds and equities has become decidedly bumpier.
At Cameron Harrison, we continue our strategic focus away from high valuation, long duration investments (other than where inflation protection is present). The Cameron Harrison Core Income Strategy has a short-duration strategy and our Australian & International Equity Strategies have eschewed the high valuation, revenue growth-only, long duration equities.
Over the next 18-24 months, it is difficult to see significant wages pressure as employment growth only slowly recovers to pre-pandemic levels (and labour utilisation was already weak pre-COVID). This is particularly the case where the services economy has suffered at the hands of COVID and it is now such a big component of an economy. So, other than one-off inflation effects, it is difficult to see sustained inflation risk up to 2022 albeit, we should expect and are likely to revert to pre-COVID inflation levels and see inflation spikes in certain segments and bond yields commensurately.
It is odd that markets are surprised or have somehow been caught off guard. The right frame is that hopefully economic and employment growth eventuates. From an investing standpoint, we doubt there is any substantial basis for significantly elevated bond rates from the current level, but overshooting is not new to markets, and if nothing else, it does highlight that capital may not be costless forever and investment may need to be more discriminating - a good thing in the long run.
From 2021 onwards, however, and insofar as fiscal policy retains stimulatory force, the cyclical uplift has the potential to lift inflation and inflationary expectations. From our standpoint however, unless the secular stagnation forces of the last 30 years can be reversed through the sustained fiscal stimulus, and in the process drive strong employment, then bond yields and inflationary expectations we think may well fizzle. If such a situation occurs, it will indeed have been ‘much ado about nothing’.
Pre-COVID we sought for economic policy to engage with both policy arms: monetary and fiscal policy. Why? We wanted higher growth, greater capacity utilisation, some wages growth and inflation. Of course, one of the likely outcomes is a steepening in the yield curve. Heaven forbid it should happen. It’s a positive outcome for the economy, but arguably not for long duration equities which have benefited from a flat and falling yield curve. It underscores there are no free lunches.
The almost linear return recovery in equities over the last 8 months always had an inevitable junction point – it’s now. The markets over emphasis on high valuation, long duration investments was always precarious, and now, even more so. We would recommend a more balanced duration profile across equities, fixed income and alternatives with more realistic profit based valuation metrics. Basically, it has got a whole lot harder for investment managers as the 30-year bond rally curtain closes. Equally, it has got a whole lot harder for central bankers. Setting and guiding short-term rates is one thing. Keeping longer term rates well-contained and the cost of debt low, having encouraged their respective governments to borrow big and spend big, will test their new skills, approach and policy bias developed over the last 30 years because the participant most exposed to rising rates is government.
Cameron Harrison have been advising business owners and their families on asset allocation and intergenerational wealth management for over 50 years. We have demonstrated over a long period our ability to manage investments through both the good times and bad by keeping the client at the centre of our business.
For more information on our approach to investment strategy or any other inquiries, please contact us on +613 9655 5000.