Industry Voice: Beyond the boundaries

Inflation is now higher than many of us have seen in our working lifetimes, and central banks have aggressively raised interest rates in an attempt to contain it.

Beyond the purely financial sphere, frictions between superpowers have been rising, and Western economies are demonstrating greater concern for national self-interest. Climate change and decarbonisation efforts are likely to affect the nature of future growth, while China, whose influence on the global economic outlook has become increasingly important in recent decades, is expected to see a continued shift away from manufacturing towards consumption.

Amid this painful regime change, all major asset classes have experienced broad-based declines, with few places to hide. In this context we think it will be important for DC investors to look forward rather than backwards and reassess their positioning.

New era, new winners?

After experiencing a rerating of assets in a disinflationary world for many years, we are now witnessing a derating of asset prices in an inflationary environment. One key implication of higher inflation is that central banks now have less flexibility to stimulate economies through interest-rate cuts and liquidity injections. Governments may also think twice before embarking on excessive fiscal largesse, after the UK government had its fingers burnt in September when attempting to implement unfunded tax cuts.

High-growth technology-related stocks were the big winners over the last ten years, and particularly during the Covid pandemic as we all worked and shopped virtually. As many of these securities have seen precipitous declines over the last 12 months, they may appear temptingly cheap today. However, it is worth bearing in mind that many of these businesses still sit on quite high multiples. In many cases, earnings are expected to grow materially, but for some of these companies the regulatory landscape is changing, while others face stiff competition.

Many investors may be hoping that their current portfolio will lead them out of the downturn, but while history may not repeat itself, a look back at previous cycles suggests that market leadership can change dramatically in such instances.

Better income outcomes

With the potential for slower growth and lower capital returns from equity markets, making the income component of returns more significant, we see a favourable backdrop for select income stocks. While it is difficult to be overly optimistic on dividend growth given the economic backdrop, in an environment of higher inflation the dividend outlook appears positive for companies with strong pricing power. Furthermore, on a global basis, we believe the valuation of stocks offering income at above-average rates remains attractive relative to below-average income stocks.

We think listed infrastructure securities, issued by companies with hard asset-owning business models which often provide essential services, can also hold up as a buffer in this inflationary environment. Infrastructure assets are generally regulated, and the revenue from them is governed by long-term contracts with built-in inflation pass-through mechanisms. As with most businesses, it is necessary to consider their ability to withstand inflationary pressures, and with infrastructure assets this feature is effectively ensured by the contracts and structures involved. Infrastructure assets typically generate stable cash flows that keep pace with inflation, and take the form of dividend-paying equities.

Could bonds be back?

Rising interest rates and high inflation have created an extremely challenging environment for bond investors in recent months, with global government bonds having been on course for their worst year since 1949.¹

Still, after the huge bond market sell-offs seen this year, the asset class could be set to fare better. While policymakers are likely to continue to increase interest rates to bring inflation back down to target, the effect of this will vary across the yield curve. Further interest-rate rises will push yields higher for short-term bonds, but the effect should be less at the longer end (such as 10-year or 20-year maturity bonds), as the market has already priced in significant interest-rate increases and may start to price in their impact on the economy, specifically the possibility of a recession in some regions.

Nevertheless, it will be important to be selective and take advantage of diverging trends. Some governments are attempting to fiscally stimulate their economies through measures such as help with household heating bills in light of the current energy crisis. In other places, there is rising pressure from organised labour for wages to increase. While this is understandable, these societal pressures and government-led initiatives are counteracting the efficacy of central-bank policies. The net result is that bond and currency markets will respond differently over different time horizons. In the eurozone, for example, interest rates have not risen as much as in the US or UK, and there may be further moves that are yet to be priced in.

The active advantage

As we head into 2023, DC schemes will need to consider how they navigate the new market regime to deliver the best outcomes for their members. We believe that an environment characterised by higher volatility and shorter business cycles than we have become accustomed to could be ripe for investors offering highly active portfolios, with the ability to carry out in-depth research into individual securities and access idiosyncratic ideas.

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