Managing the challenge of global inflation

Despite the dampening effect of rampant inflation on stock markets, active fund managers who focus on business fundamentals relative to valuations can continue to generate market-beating returns for investors, says Old Mutual Multi-Managers.

“The trick to investing during periods of high inflation is to reflect on how the different asset classes react to it, and then reposition your portfolio towards the asset class and securities that are most resilient,” says Andreea Bunea, Head of Global Equity at Old Mutual Multi-Managers.

Fund managers have had their hands full through the latter part of 2021 and the first half of this year, as the US Federal Reserve (the Fed) and other European central banks finally take steps to cool inflation.

Both the Fed and the Bank of England have hiked interest rates multiple times in response to the highest level of inflation in those countries in more than four decades. Although a more aggressive monetary policy stance is likely to have a dampening effect on overall company earnings, valuations also played a role in how prices adjusted to the changing macroeconomic environment. Equities in the US have sold off, with the US NASDAQ Index, comprising most of the technology names, down about 30% since 1 November 2021, while the UK FTSE Index remains almost unchanged over the same period. This is because US tech companies were trading on very lofty valuations prior to the selloff, while valuations of UK stocks were relatively cheaper, due to concerns over the handling of the Brexit deal as well as limited tech exposure.

Offshore equities were not the only struggling asset class. “We have already seen global bonds experiencing one of the worst years on record,” notes Bunea.

“Although South African bond yields have weakened of late, losses were muted compared to global bonds, as our bond yields were already high, and the inflation outlook in our market is not massively different from its long-term trend”.
The pros and cons of staying invested in bonds or cash vary from one country market to the next and will depend on how quickly central banks increase interest rates, among other factors.

Most developed markets are however still paying cash interest rates that are well below their inflation rates, making that asset class quite unattractive.

The final asset class worth mentioning is property, which has traditionally served as a good inflation hedge due to rental incomes rising in line with inflation.

Unfortunately, the outlook for the local asset class remains constrained due to large parts of the commercial property sector not yet having recovered from the COVID-19 pandemic. Against this backdrop, asset managers will probably concentrate on the equity asset class to generate performance, with the caveat that the merits of individual securities must be carefully considered and the sectors in which they operate?

According to Bunea, commodities have historically performed well in an inflationary environment. This is good news for a commodity rich country like South Africa, and partly explains why the JSE All Share Index has been resilient over the past couple of months.

Furthermore, high commodity prices have helped to support the rand despite anxiety over the war in Ukraine.

“The JSE is of course home to many large mining companies, and the rand is generally viewed as a commodity currency,” adds Bunea. Portfolios with domestic equity exposure should benefit from the positive outlook for both commodities and commodity currencies.

“Within the equity asset class, it is important to find companies that have pricing power and are able to increase their selling prices as input costs rise,” says Bunea.

“You can identify these companies through their strong brands, resilient business models, innovative competence and healthy balance sheets”.

Companies that are unable to hike prices face significant margin erosion which will result in lower earnings and, of course, lower share prices. Valuation is also important, especially when aggressive rate hikes are in the pipeline, as higher discount rates translate into lower valuations across the board. In this context, valuations must be considered relative to the strength of business fundamentals and investors must avoid overpaying for companies that are in demand.

“If everyone desperately wants to invest in a company with pricing power, then share prices might become stretched relative to that company’s fundamentals, and it may then be better to consider a company that is vulnerable to inflation but has most of the bad news priced in,” Bunea explains.

Global markets have adjusted to the impact of rampant global inflation on policy rates and global growth, and ultimately on global business fundamentals, but this need not cause South African investors sleepless nights, says Bunea.

“The bottom line is that any major global economic shifts, like the pandemic or the subsequent surge in inflation, creates winners and losers, and therefore investment opportunities,” concludes Bunea.

“It is our job as active multi-managers to choose asset managers that have the skill, proven track records of managing clients’ funds through the ebb and flow of global inflation and other macroeconomic factors”.