How to accelerate around an inflationary corner

Imagine driving on a straight road, and then being surprised by a corner. Initially, perhaps, one isn’t too concerned, as the expectation is that it just a mild bend in the road. But as the corner gets bigger on one, there comes a point where a decision needs to be made as whether to maintain speed, slow down, or even try to accelerate out of it.

We can think that the speed your investment portfolio is traveling at is the amount of equities you are holding in your portfolio, and persistent inflation is the unexpected corner in the road. While many of us may have come into this corner uncomfortably fast (after all, the road has been straight for much of the past decade) one doesn’t necessarily need to brake if the corner is not too sharp, while any hasty adjustments to the steering wheel might take one off the road.

As things stand today, consensus is that the corner will be okay. According to the market, the US Federal Reserve won’t hike much past 3.5%, which is significantly less than how they have responded in the past to comparable higher inflation. At the same time, participants argue that global inflation may already have peaked, and while central banks are still expected to raise rates multiple times in the next 12 months, they could be cutting towards the end of next year.

The challenge to this view is that the current environment remains highly uncertain, and it’s hard to see clearly where inflation is going. This is especially true because it has been difficult for global supply chains to respond with increased supply to higher prices, given their dependence on Russian and Chinese economies (and the intent from many western companies to diversify away from both), as well as the complexity of de-carbonizing the supply chain more generally.

Consequently, there are non-negligible grounds for expecting inflation may be higher for much longer than expected, and central banks could be forced to respond with very aggressive interest rate hikes, so that even equities with some pricing power in an inflationary environment will come under significant pressure. By way of an analogy, just like investors were surprised post-2008 with how low interest rates remained for much longer than expected, so today the converse may be true at interest rates remain higher for much longer than expected.

What then as an investor should one do? Those of us that slowed down well before the corner need to decide whether it is now safe to speed up. Unsurprisingly, perhaps, most of these investors have remained defensively positioned for the time being. Equally unsurprisingly, of course, the more aggressive drivers have already decided to slam their foot on the accelerator, given their assessment that we are already far enough into the corner to speed up.

On the other hand, investors that feel they have come in here quite fast will have gotten a sense of how their portfolio behaved over the past six months, and whether there are small adjustments they need to make to improve their handling, or large adjustments they need to make to reduce the maximum speed of their vehicle.

Small adjustments may include a bit more cash in the tires of the portfolio or rearranging the suitcases so a particular bag on the roof (or manager style in the portfolio) doesn’t cause the car to sway precariously. In contrast, large adjustments would be ensuring your portfolio can only go a certain maximum speed, if you inadvertently constructed or climbed into an investment portfolio that can go faster than you are comfortable with.

As a multi-manager, we try to drive smoothly around corners, and try to avoid having to frequently change our speed. We carefully consider the speed each portfolio is expected to go and try to keep to a driving style that allows the managers we select to deliver most of the outperformance. We do this by ensuring we are driving a carefully diversified portfolio and keeping on our eyes on the road. In the long run, we think this is the best way to get our passengers to their destination.

By David Crosoer (Chief Investment Officer at PPS Investments)
and
Prieur du Plessis (Chair of the PPS Multi-Managers Investment Committee)