A rise in inflation might be around the corner and institutional investors would do well to prepare for this risk, MLC’s Jonathan Armitage says.
Inflation is a term that has almost been written out of the financial dictionary over the past decade as quantitative easing programs have pushed rates lower and lower.
But institutional investors would be wise to put it back on the agenda as the risk of an unexpected rise is not out of the question, according to Jonathan Armitage, Chief Investment Officer at MLC Asset Management.
“My personal view is that whilst people are starting to think about it a little more than they have done, inflation is still an underestimated market risk,” Armitage says in an interview with [i3] Insights.
“To be clear, I don’t think we are going back to the 1980 levels of inflation, that is very unlikely. But there is still a big difference between 2 per cent inflation, which is discounted now, and say 3 per cent. So I think the risk is that the market will be taken by surprise.”
Armitage, who is responsible for MLC’s multi-asset portfolios for both retail and institutional clients, has taken several steps in his portfolios to address the risk of higher inflation.
My personal view is that whilst people are starting to think about it a little more than they have done, inflation is still an underestimated market risk
“We have been focused on increasing our exposure to emerging market equities. Those are markets that tend to benefit from slightly higher inflation levels. That is also coupled with the fact that valuations look pretty attractive as well,” he says.
“We have also increased our exposure to inflation-linked bonds, particularly here in Australia, and we reduced our nominal bond exposure to particularly low levels.
“I think that if inflation was to very rapidly accelerate, you could see equity markets pull back and we’ve got a number of protection strategies over our equity exposure, which would mitigate a sharp reversal in equity markets.
“[Considering] where we see these current risks, we are very comfortable with the positions that we’ve taken.”
Changing Perceptions
At the end of January, the Reserve Bank of Australia (RBA) said it expected inflation to remain subdued for the coming years. “Inflation in underlying terms is … forecast to stay below 2 per cent over the next couple of years,” Philip Lowe, Governor of the RBA, said in his opening statement to the House of Representatives Standing Committee on Economics.
But Armitage is a little more careful as markets have changed the way they perceive inflation quite dramatically in the past 12 months.
“If we go back to March last year, when the pandemic really started to impact the global economy, markets started discounting a deflationary scenario,” he says.
“And then as you saw government and central bank intervention, by the middle of last year those inflationary expectations were starting to shift a little bit. Perhaps a better way of putting it is that markets started to reprice inflation risk away from significant deflation risk.
“And so we get to a situation where we are today, where if you look at current break-even rates in the markets, they are just under 200 basis points here in Australia, so by historical standards that probably looks quite subdued, but it is a different picture than where we were 12 months ago and even eight or nine months ago.”
Our point is that inflation expectations have been so low, that it wouldn’t take very much for those expectations to change. Markets have been pricing in incredibly low inflation expectations and again it wouldn’t take very much for markets to adjust prices, possibly quite sharply
Market perception of inflation can change rapidly and Armitage is keeping a close eye on indications of a potential rise in prices. He points out the coronavirus pandemic has delayed a lot of expenditure and once this comes through, prices could push higher.
“There is a mixture of things around pent-up demand, particularly around recreation consumption, global travel and those sorts of things,” he says.
“And it is interesting to see that some commodity prices have started to move up. You have certainly seen some quite robust increases in commodity prices over the last 12 months or so. All those sorts of things add to input prices starting to move up.
“Our point is that inflation expectations have been so low that it wouldn’t take very much for those expectations to change. Markets have been pricing in incredibly low inflation expectations and again it wouldn’t take very much for markets to adjust prices, possibly quite sharply.”
False Inflation?
The global pandemic has caused widespread disruptions in supply lines and while there are few products with real shortages, there could be instances where short-term supply issues could push up prices temporarily.
Asked if there is a danger that some of these price swings could be mistaken as early warning signs of rising inflation, a kind of false inflation, Armitage answers that this is an important thing to consider.
“For example, there seems to be a bit of a shortage of microchips to go into car parts. It is impacting European car manufacturers more than anyone else, but that is impacting supply,” he says.
“It probably doesn’t impact what you pay for a new car, but it may impact what is happening in second-hand car markets and you are actually seeing a little bit of that feed through here in Australia.
“But something like that is probably more temporary.”
Data coming from the United States seems to indicate more lasting changes, he says, particularly when looking at labour data and leading indicators such as the ISM Manufacturing Prices Index.
“What I think is more interesting is that prices paid by manufacturers are pretty much near a high for the last decade. And you are starting to see labour costs rise in the last quarter as well,” he says.
“In the last 16 months, labour prices have risen the most over the last decade. Now, those changes are less transitory. It is not inconceivable that you will see the same thing occurring here in Australia.”
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[i3] Insights is the official educational bulletin of the Investment Innovation Institute [i3]. It covers major trends and innovations in institutional investing, providing independent and thought-provoking content about pension funds, insurance companies and sovereign wealth funds across the globe.