Mitigating inflationary risks in your portfolio

Well, inflation may have eased from its peak, but the bigger question is whether this is a pause or a structural shift, particularly given the pressure we're seeing from fuel prices.

Well, earlier I caught up with Chris McDonough from T.Rowe Price to unpack how the oil price shock is forcing investors to reassess their outlook.

Oil price shock that you, everyone in the world is going through. Australia is at the front lines, unfortunately.

You know, petrol prices are certainly surging.

They're surging here in the United States as well.

And so that's causing investors to reassess, reassess how inflation is evolving, right?

And for a lot of investors over the last several years, they've watched inflation normalizing and moderating and thinking that this is a return to a more normal environment like we had in the past 15 years after the financial crisis.

And I guess my message to investors is really we're in a different era where it's, it's my view that the underlying drivers of inflation are much broader.

It's not just about oil price shocks; it's about broader shocks to the economy that mean that inflation is structurally higher for longer than people than the market certainly is pricing in and anticipating.

Interestingly, you talk about perhaps that inflation comes in waves, and I guess that's very applicable right now.

Certainly, here in Australia's an expectation perhaps there is somewhat of a lull.

Those prices are moving higher, but perhaps the full effects yet to be felt from those, the oil price shock.

Yeah, no, that's right.

What's really interesting is we've noticed in the research that we've done that it's very common for inflation to have multiple waves, right where you get an initial shock to the to prices, inflation goes up, It then moderates and comes down.

And that gives investors, policy makers, households the feeling that inflation has gone back to some more normal trend before it surges yet again.

And effectively what seems to be happening is the first shock helps to, to essentially make the economy more susceptible to that's the second round shocks.

That's the first problem.

The second problem seems to be that when you get these really large inflation shocks like we did in the 70s, even in the 1980s and occasionally in in the 2000s, really what seems to be happening is it's reflecting kind of a dynamic where there's some geopolitical forces, there are underlying tensions of the economy, fiscal policy is too loose or monetary policy is too loose.

Those problems never really get resolved.

So unless you deal with the structural underlying forces driving inflation for the first shock means that it doesn't take that much, that much to see inflation go up again with any other shock that comes along to the economy.

Now that’s on the shock.

I was going to say and that's on the cyclical on the structural side.

I think we're also in a really unique environment cyclically as well that hasn't gotten much attention by investors.

And that is China is really moving out of the deflation that it experienced in right after COVID.

So just after they opened up in COVID, their economy took a really large hit and it it's effectively been acting as a lid on prices over the last three to four years.

In the last couple of months, even before this oil price shock, we saw signs that lid was coming off and therefore was going to act as an accelerant to prices across the across the globe.

I mean, in Australia, I've always been struck by them on the streets in Sydney.

You're a real beneficiary of that Chinese disinflation.

And you have BYD cars everywhere, right?

And that means that you get, you know, really fancy nice automobiles that we don't get here in the US and they're, you know, cheap.

And so that helps to keep inflation low.

You know, across the globe, that dynamic seems to be ending.

And that was even before this, this crisis in the war in, in Iran.

Now, Chris, another issue feeding into inflation is fiscal policy.

That's certainly in sharp focus here in Australia ahead of the federal government budget next month.

But I, I see you've actually identified the big issue is actually at a state level where perhaps they've showed a lack of restraint there in spending.

Yes, this is something that's been a theme that I picked up on in my visits to Australia.

And that at the federal level.

Typically fiscal policy is set so that the government, the Commonwealth government sets the overall trajectory of the, the fiscal spending and where you know, how that filters through to the rest of the economy.

In the last several years, however, for a variety of reasons, the Commonwealth, the states have actually embarked on some pretty large spending programs, pretty large infrastructure programs.

And what that mean has meant is any fiscal restraint at the state level or a sizeable amount of it has been offset at by the by the states.

So you have the Commonwealth government trying to potentially step back a little bit, but without fiscal restraint.

But at the state level that that just means the overall stance of fiscal policy is that much looser.

And then it makes it harder for the central bank, in this case the RBA, it makes it that much harder for them to react into adjust to inflation.

Here in the US, we have a slightly different problem.

It's not so much a state problem.

It's our federal government has had spending that's at really record levels.

I mean our economy is essentially at full unemployment, unemployment rates at 4.5% in the US, typically you would expect a, a budget deficit of around 2%, no more than that, sometimes even surplus because your economy is just doing really well and the government should be collecting a lot of tax revenues and there shouldn't be real need for spending.

But unfortunately we've got a fiscal deficit of around 6.5%t of GDP, which is quite large, typically associated with recessions.

So again, you know, this, this dynamic is true not just in Australia, not just the United States, but across the globe, across a lot of developed markets.

We have really fiscal policy that seems to be adding another, another, you know impetus to the inflation to inflation dynamics over the next several years.

So Chris, as an investor, how do you account for higher inflation and in particular, does that traditional 60/40 portfolio work?

Great question.

And you know, the 60/40 portfolio has been a fantastic invention for investors over the last 40 years.

It's worked really well.

Essentially you've had bonds in your portfolio that have acted like a ballast so that anytime a shock, you know, negative shock came along, they those bonds helped to offset, you know, the losses in your stock portfolio.

So you have this nice dynamic where you can get growth through the stock portfolio and then when risks seem along, the bonds would protect you.

Unfortunately, that works. I mean that works in most environments, but unfortunately it doesn't work when inflation comes along.

And why is that?

It's essentially what happens is when you get high enough inflation, then you then you've got equities that take a hit on the discount rate and then bonds have to price in the central bank taking action to bring inflation back down under control.

And so you have both bonds selling off because, you know, inflation is acting as a, as a tax and slowing is out, you know, lowering valuations and, and making it more difficult for companies.

But then bonds take a hit as well.

And now for most people, they think, well, this dynamic should be, you know, for hyperinflation.

Unfortunately, our research has shown that it only takes inflation of around 2.5% or so in the United States for that correlation, that kind of nice correlation between stocks and bonds that that flips at a relatively mild inflation rate.

So structurally, if inflation is around 2.5% to 3%, you can have that stock bond correlation flip becomes positive

And so you need something else in your portfolio to help offset that inflation shock.

So that brings the question, Chris, how do you mitigate those inflationary risks particularly amidst heightened volatility?

Exactly.

Now for us, the way we've protected our portfolio is to look at a variety of different asset classes and ask the question what provides you that protection and what we found is the right mix of real assets helps do that for you.

So essentially having energy companies, mining companies and other and other cyclical but companies, but to hide to the commodity sector so that when inflation comes along initially though they those companies tend to be the ones that benefit from it and those companies then have their earnings and valuations reset higher and offer a nice offset.

But we also want to ask the question, how can you protect your portfolio if inflation comes along, but then stay sustained.

So you also want companies that have pricing power and ability to extract returns and income over time that's linked to inflation, right.

So in other words, their earnings really not only grow with inflation, but an inflation plus.

And we found real estate and infrastructure companies do that as well.

So by having a nice mix of both real estate and companies in the long term and then the cyclical commodity companies for the short term response, mixing those 2 together in your portfolio provides a nice balance and helps protect against these inflation shocks.