Stagflation is a buzzword in global markets at the moment. Is it really back to the 1970s? And what would that mean for investors? Pendal portfolio manager Amy Xie Patrick explains in this fast podcast

Listen to the podcast above or read the transcript below

Interviewer Sean Aylmer: Stagflation. It’s a word we hadn’t heard for a long time, but in the last few weeks or months, suddenly it’s getting an airing again. What’s behind that?

Amy Xie Patrick, portfolio manager, Pendal Income and Fixed Interest team:

Absolutely. I think the last time we heard about the word stagflation, and when it really was a theme, was when we thought about the oil shock crisis that happened in the ‘70s.

I think what’s happened again this time round is that commodity prices, and these energy shortage stories — all the way from Europe, throughout China and hitting a lot of emerging markets as well — is making people think we’re going through the same set of circumstances again, which could trigger stagflation this time round.

But I do think that for stagflation you need really growth to stall – not just slow – and you need inflation to be skyrocketing.

I think stagflation as a word to characterise what we’re going through right now is a bit of an exaggeration.

Interviewer: Okay, so they’re overplaying the slowdown in growth and they’re overplaying the rise in prices – and that’s why we’re hearing stagflation?

Amy Xie Patrick Exactly. I think what’s behind the rising prices is several fold.

Obviously because of the Covid pandemic and the crisis that ensued, there was a massive drop-off in demand.

---

More Pendal podcasts

---

Whenever there’s such a massive drop-off in demand, the capacity always adjusts. The same goes for commodity capacity. The same goes for energy and fuel capacity.

When that capacity falls, it takes a long time to come online again. Furnaces don’t just get switched back on. Miners don’t manage to suddenly turn on a lot of capacity very easily.

As a result, as you’ve seen demand recover from the depths of the pandemic, the supply hasn’t been able to really catch up.

So this is the first point that goes against this thesis of stagflation.

Demand is recovering. Vaccination rates are starting to really climb globally, even for those parts of the world that were really lagging at the beginning of the vaccination drive.

And as we see economies continue to open up, that demand recovery will continue to underpin some of the overall growth recovery that we’re seeing globally.

So by no means do I see a picture where growth is suddenly stalling or going backwards.

And then on the inflation side, it’s not just supply bottlenecks that are causing the fuel price rises and the commodity price rises. The demand side of the picture also seems pretty robust.

On the supply side, we have been told by a lot of policymakers in the central banks, not to worry about inflation because it is transitory. But some of them are starting to scratch their heads and think about how transitory.

I do think it probably leaves you with an inflation outlook that is slightly less comfortable than what we’ve been used to for at least the past five years.

Inflation – both headline and core – is likely to sit at or slightly above what central banks have as their targets.

Australia perhaps is one of the exceptions, because the RBA does target the middle of their ranges – 2.5 per cent as opposed to the rest of the world which largely targets 2 per cent.

But overall, just because inflation will sit at a slightly higher level than what we’ve been used to for the past five years, it doesn’t mean an inflation surge that suddenly becomes out of control.

Interviewer: So bringing that back to portfolio construction, if I’m hearing you right, we still have the same problem that we had six months ago. We may still have the same problem in six months time.

Amy Xie Patrick: Absolutely. You may not see yields go back to their all-time lows.

But by no means, are you going to see yields come back to the comfortable 4 per cent, 5 per cent or 6 per cent ranges where we can happily accrue a loss of income from our traditional fixed income portfolios.

Therein lies the problem for a lot of fixed income investors globally – and in fact portfolios as a whole.

If you’ve got still a lot of risk in your portfolio that is much more equity-beta driven, how then do you offset some of that risk with something that can be negatively correlated when those equity markets get into trouble – and in the meantime is still able to generate you sufficient income to offset some of those transitory or structural inflation concerns that are coming up?

I think that is the real challenge right now for fixed income portfolios.

For us at Pendal it really means thinking about using all the tools available to you in your toolkit.

Breaking down those traditional thinkings about the boundaries between asset classes and the boundaries between bonds and equities.

Thinking about where you can derive income from and where you can best use your levers to generate that alpha and those returns for still a very low-yielding world.

Interviewer: So how should we think about portfolio construction?

Amy Xie Patrick: Naturally it means you get pushed further out along the risk curve within fixed income.

You rely less on high-quality government bonds in the portfolio to provide you with that income, but you still leave enough of an allocation to those government bonds for safety.

For times, when you do get that sudden knee-jerk drop in equity market prices.

In the interim you search for income further along the risk curve in areas such as high-quality corporate bonds, but also diversifying into assets such as emerging market sovereign credit.

And that is ultimately the philosophy of how we make our income products.

The idea is to be able to generate steady enough income, that won’t be jeopardised by the quality and default risks within your income-generating engine of the portfolio. And still keep some of that protection going with an allocation to government bonds in the background in case you need it.

 

The days of holding a set-and-forget 60:40 portfolio are over, says Pendal’s Vimal Gor. Investment managers need strategies and sub-strategies within a defensive portfolio. Here’s why

• 60:40 portfolio construction is no longer enough
• Investors need to look for more advanced defensive strategies
• ‘New way of thinking’: Vimal Gor

THE DAYS of set-and-forget portfolios are over and successful investing today requires actively managed defensive strategies, says Vimal Gor, who heads up Pendal’s Bond, Income and Defensive Strategies team.

Traditional investment wisdom says investors can run a portfolio with 60 per cent equities and 40 per cent bonds and get exposure to rising markets while enjoying protection when things turn down.

But policymaker action to keep interest rates low means bonds no longer play the role they once did in a portfolio of providing income alongside downside protection, Gor says.

“People know their fixed income defensive portfolio is broken — they just don’t know what to do with it,” says Gor, speaking at Investment Magazine’s recent Absolute Returns Conference.

“They are navigating this period where the 60:40 portfolio is no longer as relevant as it was in the past.”

Gor recommends investors take a whole portfolio approach and build strategies and sub-strategies within the portfolio that perform at certain times.

“The key thing for clients is that you want to have confidence in the defensive part of the portfolio to perform when you need it.”

The idea is to avoid an asset-class approach and recognise that defensive strategies can be found across the markets, he says.

“It’s like a new way of thinking about it. You’re not so much trying to put together types of asset classes and then getting an outcome, it’s really a focus on the outcome first.

“If the equity markets are all down, what do I need my defensive book to do? And do I have confidence that it will actually work or not?”

Volatility as a strategy

That approach has led Gor to use volatility as a trading strategy, adding equity volatility in recent years and even using cryptocurrency to provide defensive protection.

“It’s really about making sure we’re thinking about the whole portfolio as opposed to saying here’s a fixed income fund.”

Relying on bonds and traditional portfolio construction strategies is effectively equivalent to using old technology, he says.

“We’ve got to this point where there’s complete death for the 60:40 portfolio and if we get bond yields rallying further well then risk parity is largely dead as well.

“But then how do you think about building that defensive path?

“If you don’t use volatility and you don’t use equity vol and you don’t use strategies like intra-day momentum – these kinds of things which are proven to be defensive – well then just relying on an old product set isn’t going to get you to where you want to be.”

 

What impact will China’s economic slowdown have on Emerging Markets investors? And what are the alternatives? Here’s a quick overview from Pendal’s James Syme and Paul Wimborne

THERE has been substantial media and analyst commentary around the changing political and regulatory environment in China.

Important as this is, we think it is at risk of overshadowing what economic data releases in July and August have shown about the Chinese economy: genuine economic weakness across the board.

Almost every Chinese economic release in those months was weaker than the previous data point, and below expectations.

A selection of this month’s data would include:

• Retail sales (July): +8.5% year-on-year compared with consensus expectations of +10.9% and a previous print of +12.1%)
• Industrial production (July): +6.4% year-on-year compared to consensus expectations of +7.9% and a previous print of +8.3%)
• Property investment sales (year to July): +12.7% year-on-year compared with consensus expectations of +12.9% and a previous print of +15%
• Caixin Manufacturing PMI survey (August): Down to 49.2 compared with 50.1 expected and 50.3 in July.

More ominously, the datapoints that we believe lead the real economy were also soft.

M2 money supply growth in July declined to 8.3% year-on-year and growth in claims on the financial system declined to 7.4%.

These together reflect monetary policy as tight as that in the 2018/2019 period.

Bond yields are also suggesting a slowdown. Chinese government 10-year yields are lower by 0.3% year-to-date. This is during a period when most countries’ sovereign bond yields have risen.

Despite this, commodity prices have not reacted as might have been expected.

Copper has remained around US$9400/t, having started the year at about US$7700/t.

Iron ore has come back to US$145/t from its US$235/t peak in May, but is only slightly lower than its US$156/t start of 2020.

From an equity investor’s viewpoint, MSCI EM Materials has performed well year-to-date and in the past two months.

We cannot see this lasting and we remain zero-weight industrial metals producers in the portfolio.

Brazil and South Africa upcycle

We continue to hold overweight positions in Brazil and South Africa, both of which are major commodity producers.

Why are we less concerned about these markets, given our view on the direction of the Chinese economy?

Emerging economies can generally be thought of as having a trend rate of economic (or earnings) growth, and then a business cycle around that trend.

Even if the medium-term trend is less attractive, markets undergoing a strong business up-cycle can offer compelling opportunities for investors.

This is what we believe is the situation in Brazil and South Africa.

In the eight years that followed the 2002-2011 commodity boom, Brazilian GDP growth averaged just 0.5% year-on-year. Unemployment climbed from 5.2% to 11.3%.

This period saw a significant slowdown in credit growth and a strong increase in the trade balance (reflecting weak domestic demand).

Domestic demand had begun to recover towards the end of this period (for example, car sales bottomed in 2016 and unemployment bottomed in 2017). But the impact of Covid delayed the recovery.

Risks remain, including the timing of the peak in inflation and interest rates and political risk from the October 2022 election.

But we continue to see Brazil as an economy with the economic and financial conditions to stage a near-term recovery in domestic demand — towards what we fully recognise is a mediocre trend rate of growth.

A slowdown in China, with lower commodity prices, may further reduce that trend growth rate. But it will not, we believe, prevent the recovery.

South Africa finds itself in a similar position.

In the 2012-19 period, South Africa experienced average GDP growth of 1.4% with weak credit growth and a deleveraging of the private sector and rising unemployment.

South Africa had not even begun to recover before Covid hit — yet the improvement in the trade balance was much stronger than in Brazil.

We feel South Africa will also stage a recovery back towards trend growth levels in the quarters ahead. We expect opportunities in domestic demand, while recognising urban unrest and new Covid variants are risks that must be monitored.

We do not see a 2021 slowdown in China preventing that recovery.

Some emerging markets are commodity exporters. But neither the economies of those countries nor their equity markets have mechanical linkages to commodity prices — and there will be periods of opportunity in the face of softening export prices.

We believe the second half of 2021 will be such an opportunity.

---

About Pendal Global Emerging Markets Opportunities Fund

James Syme and Paul Wimborne are senior portfolio managers and co-managers of Pendal’s Global Emerging Markets Opportunities Fund.

The fund aims to add value through a combination of country allocation and individual stock selection.

The country allocation process is based on analysis of a country’s economic growth, monetary policy, market liquidity, currency, governance/politics and equity market valuation.

The stock selection process focuses on buying quality growth stocks at attractive valuations.

Find out more about Pendal Global Emerging Markets Opportunities Fund here.
 
Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management.

Contact a Pendal key account manager here. 

Significant Features: The Pendal Active Moderate Fund is an actively managed diversified portfolio that invests in Australian and international shares, Australian and international listed property securities, Australian and international fixed interest, cash and alternative investments.

Fund Objective: The Fund aims to provide a return (before fees, costs and taxes) that exceeds the Fund’s benchmark over the medium to long term.

Investment managers analyse green investments against a range of benchmarks, but it boils down to three things, says Regnan’s MAXIME LE FLOCH

• Is it really green? Is it the best solution?
• How does it look long-term?
• Find out about Regnan Global Equity Impact Solutions Fund

FOR professional investors ESG benchmarks are now integrated into regular decision making. For individual investors, that’s not yet the case.

A recent Gallup study showed smaller US investors don’t spend time focusing on Environmental, Social and Governance factors when making investment decisions — and the majority don’t know much about it.

But that’s changing. The survey showing an uptick in smaller investors’ interest in responsible investing. And recent political outcomes, including the success of the Greens and independents in the Australian federal election, will force greater focus on ESG at a policy level.

So how should a small investor approach ESG?

“Start by make sure what you’re considering is actually green”, says Maxime Le Floch, an analyst with Regnan’s Global Equity Impact Solutions team.

“Second, focus on solutions with a strong relative advantage over competitors.

“And finally, focus on long-term opportunities.”

1. Make sure it’s green

Investors need to define what green is to them, Le Floch says. “There’s a spectrum of how green investments are and debates around that within scientific communities and within industries.”

“These are very complex multi-dimensional issues and it’s not just about climate change. It’s also about ocean health, foods, wastewater and many other issues,” he says.

Investors need a framework to benchmark green investments, and the United Nations Social Development Goals (SDGs) are a good place to start.

“That’s the roadmap. From there you need to do some work in terms of translating the goals into actionable investment ideas and that takes research. It might be around offshore wind, new types of plastic, recycling technologies or water treatment.”

As part of their impact assessment of companies, Le Floch and the Regnan team employ various tools such as life-cycle analysis.

This considers the full life-cycle of a product — from raw materials to production to use to disposal or recycling — and consider all environmental impacts in each stage.

2. Relative advantage of a solution

There is seldom just one ESG solution to a challenge and investors need to consider which is the best outcome for a problem.

“It’s important to not just look at the environmental benefits of a technology but also how it performs relative to other technologies,” Le Floch says.

The simplest example is the automobile sector. Internal combustion engine cars have become less pollutant and with the introduction of hybrid vehicles, the improvement has accelerated.

“But they can only go so far. Electric vehicles provide much greater environmental benefits and have a cost profile that’s getting more attractive. When you include how much you pay for petrol, maintenance and the depreciation of the vehicle, cost parity is coming much faster than was expected,” Le Floch says.

“An investor wants to be exposed to a green asset where the relative advantage has reached a point whereby there is accelerating growth coming to those solutions.”

3. Invest for the long-term

Investing for the long term is more important today with rising inflation, Le Floch says.

“It’s really important to stay focused on the long-term opportunities – the total addressable market, structural opportunities, the need to decarbonise that is recognised by governments, companies and investors.

“There is a big increase in the number of companies aiming for net zero carbon emissions. That will create demand for offshore wind power, for example. There are these types of structural drivers from companies making net-zero decisions.

“Investors should focus on areas where there are structural growth opportunities – offshore wind, wood-based fibres, water treatment solutions,” he says.

Green assets are attractive because their environmental benefits are going to be increasingly recognised and rewarded, Le Floch says.

“There will be higher demand for these technologies if they can prove they are benefiting the economy and that’s what investors should look for.”

---

About Maxime Le Floch

Maxime is an analyst with Regnan’s impact investment team. He focuses on Regnan Global Equity Impact Solutions Fund. Maxime has more than 10 years of experience in sustainable investment. Before joining Regnan he was an investment analyst with Hermes where he helped launch and manage the Hermes Impact Opportunities Equity Fund.