Stability through divergent inflation scenarios

Nick Balkin is a Portfolio Manager at Foord Asset Management, the managers of the Nedgroup Investments Stable Fund. The Stable Fund is a slightly ‘riskier’ fund with a maximum exposure of 30% to equities and a key objective to deliver an inflation plus return over rolling 3 years and to protect capital over a rolling 1 year. Nick discusses how to achieve stability through divergent inflation scenarios.

Performance to 1 March 2021
We had very strong performance over the 1-year period of 16.2%, both in absolute and real terms. Our longer-term numbers of 9.4% over 10 years and 9.2% over 3 years also show a very stable and strong performance in absolute and real terms and ranked second out of 54 funds for the 10-year period. The sectors that contributed to performance over the quarter were equities (0.4%), property (0.4%) and foreign assets (1.2%). Interest bearing and other assets returned -0.5%. All sectors contributed to the 1-year performance with interest bearing (7.7%), foreign assets (6.1%) and equities (4.0%) the top performing sectors. The key performance drivers were asset allocation and stock selection. We were low SA equities, low SA property and low SA Inc. We were high SA bonds and were invested in our full allocation to foreign equities. The biggest negative was the low allocation to resources, but we think this will be the right call in the long term. We believe we need to proceed with caution. We think there are lots of stocks that aren’t linked to the economic cycle, so in good and bad equity markets we aren’t playing the go-go stocks that need the market to continue up in order to perform. We don’t need to have the highest expected return stocks.

The rising long-term inflation risk
Investors are feeling bulletproof. If you look at the high yield debt market, there were spikes around the GFC and Covid, but we are now at the lowest point of the graph. Money has flooded into the market in many different ways and people are generally complacent. Some of the reasons for this complacency includes the trillion dollars or more that has been added to consumers’ wallets. This was fine when things were very hard, but it’s difficult to take away the punchbowl. Disposable income is unnaturally high. We worry that people are looking at their current disposable income and thinking it is sustainable. There is no doubt that things are good, but are they that good, especially given unemployment rates? This is why we’ve seen a positive bounce back in some of the big developed markets with the punchbowl still remaining, whether it’s the Fed or the government passing through stimulus. We need to think about how that will unwind. The stimulus is filtering into the real economy. The retail sales line is largely a parabolic line upwards, which should scare anyone. This is because money has come in at the same time that things are getting better. We have two big waves hitting each other. The one is the monetary stimulus and the other is the demographics, which are very poor. People are ageing and you’ve got improving tech development, which is deflationary to some extent. There will be short-term inflation, but the question is, is inflation getting out of control? We think there is a risk of inflation getting out of control and we need to be worried, but you need to have a balance in a portfolio. Equities with pricing power is the place to be through the medium term to keep up with inflation. We think that SA bonds offer high real yields. The majority of our portfolio is in mid-duration bonds and we have gold as a diversifier. Some of the global themes we are looking at are the buying power of an ageing population, technology, the rise of the Chinese consumer, experience over product, monetary debasement and feeding the world.

Be prepared for multiple scenarios
In a low or high inflation world, equities with pricing power are essential. In a hyperinflation world, gold becomes a great diversifier, but bonds not so much. With deflation, bonds will make the returns. So you need to have a balance of gold, bonds and equities with pricing power, with the Rand hedge as an additional element.

Fund positioning
Our positioning has remained largely unchanged over the last year. The foreign allocation is fully invested (32.5%). We saw a small uptick in domestic equities (9.7%) as we found opportunities in the sell-off. Our bond weighting remains very high (35.3%). This doesn’t add to the risk in our minds as a lot of the bonds are in the belly of the curve with capital coming back over the next five years. It remains a very well diversified portfolio. The top holdings include 25% in the R186 and the Foord Global Equity Fund and Foord International Fund, which account for 36%.