Dear Advisers and Investors
As I was sitting down to write to you for the last time this year, I was struck by how difficult it is to sum up 2020. No words seem adequate.
The COVID-19 pandemic still overshadows everything. Despite Australia’s containment success, the story elsewhere is concerning.
Infection rates in the northern hemisphere have been rising so quickly that countries such as France, Germany and the UK have reimposed restrictions.
Infection rates in the United States are now nearing 200,000 a day,1 and tragically, more than a million lives have been lost globally.2
However, there are also reasons for hope with reports that vaccines may be available in the first half of next year. The Australian government, for example, has entered into 5 separate agreements for the supply of COVID-19 vaccines, if they are proved to be safe and effective.
COVID-19 doesn’t respect borders and so it’s essential for vaccines to be available across the world. This would be a massive boost for confidence and begin to create the conditions for a return to normal economic and social life.
Despite encouraging news on vaccines, there’s also a cautionary note. Health experts are of the view that COVID-19 won’t be completely eradicated, even with vaccines. Rather, we will have to live with it in some form, albeit with increasingly better management of the virus.
Higher inflation around the corner?
As to what other themes MLC’s investment team have on our radar, I’ll return to a point I made in my message to you in August.
Investment professionals need to guard against the danger of becoming so consumed with issues immediately in front of us that we fail to pay enough attention to what’s around the corner, which could have even greater long-term ramifications for clients.
One of those ‘around the corner’ themes is the possibility of higher levels of inflation.
It might seem a little strange to be discussing the potential for higher inflation given that Australia, along with other wealthy countries, has been struggling to lift inflation rates to levels set by central banks like the Reserve Bank of Australia.
Just as people who grew up in the 1970s couldn’t imagine a low inflation future as they’d become conditioned to high inflation, there’s a risk that many of us can’t imagine higher future inflation because we’ve become accustomed to unusually low inflation.
In 1980, US inflation, as measured by movements in the Consumer Price Index (CPI), hit a now unfathomable 15%. In response, US Federal Reserve Chairman Paul Volcker aggressively fought back by increasing the prime cash rate to 20% by the middle of 1981. Doing so effectively broke the back of US inflation.
Volker’s success became the model for central bankers globally, setting in train a trend amongst central banks to manage their economies to inflation targets. Any time inflation even looked like getting up, central banks would increase interest rates to stomp on it.
In the decades that followed, investors, economists and policymakers have continued to look out for hints of resurgent inflation. But as data has shown, inflation has become ‘the dog that didn’t bark’.
Having kept inflation in the cellar for so long, central banks have, since the GFC, unsuccessfully tried to lift the inflation pulse with ultra-low interest rates and quantitative easing.3 Despite their best efforts, undershoots of inflation targets have become common place.
Now, though, there are reasons to think that the deflationary trend may be weakening, or even ending.
Transitioning from globalisation to on-shoring
The supply of low-cost emerging markets’ labour has been a major driver of lower wages and prices. There’s been an about-turn in recent years as wages have been rising in these countries, particularly in Asia.
The pandemic has also highlighted many companies’ and countries’ vulnerability to global supply chains.
In response, companies are now looking to bring production closer to home, including on-shoring. Governments are under pressure to ensure security of supply of essentials, such as medical equipment and pharmaceuticals.
In other words, we may be transitioning from lowest-cost, ‘just in time’ production to relatively higher-cost, ‘just in case’ production. This type of de-globalisation will result in higher wages and prices.
Use inflation to deal with government debt
Countering the economic impact of the COVID-19 pandemic with much-needed support programs has greatly increased government debt and this is raising worry about passing on massive liabilities to future generations.
Still, governments are going to have to remain spenders of first resort until normal social and economic life returns, and unemployment heads sustainably downwards.
How to manage ballooning public debt is occupying policy makers’ minds. One solution is to inflate the debt away. If governments can keep inflation higher than interest rates, then all else being equal the ‘inflated’ taxation revenue pays down the debt faster, essentially inflating the debt away.
All of this adds to our view that global economic trends coupled with the evolution of government and central bank policy towards reflation makes it highly unlikely that real interest rates can rise meaningfully from here.
To be clear, ‘higher inflation’ doesn’t have to mean horrendous 1970s type inflation, just inflation that’s above current unusually low expectations.
With the above in mind, we are increasingly seeking exposure to a diverse set of assets that offer some degree of inflation protection at a reasonable cost.
We believe that cyclical stocks that rely heavily on economic growth and commodities currently offer cost-effective ways of benefiting the portfolios from a reflation scenario.
We are very mindful of the potential downside for cyclicals and as such are researching efficient ways of marrying downside protection to strategies that we think fit a ‘participate and protect’ approach.
Emerging markets and miners are examples of sectors where this type of approach makes sense, and we continue to research other investments with similar properties. Investing in the government bonds of countries which provide access to higher interest rates and currency benefits is another area we believe helps in this regard.
The way we are preparing for potentially higher inflation is consistent with MLC’s investment approach honed over more than three decades.
We strive to get ahead of risks and turn them into opportunities by providing clients’ portfolios with diversification across many dimensions. This means that we aren’t reliant on a single asset class or investment theme for success.
Doing so has helped to bring clients’ portfolio through the tumultuous events of this year and we believe it will serve clients in the years ahead.
Finally, I’d like to end with my wishes to you for a safe and restful holiday season. My investment team colleagues and I are privileged to serve you.
Chief Investment Officer, MLC Asset Management
1 U.S. nears 200,000 coronavirus cases in a day as Pfizer plans to seek vaccine greenlight. Hannah Knowles, Hannah Knowles, Carolyn Y. Johnson, Darren Sands, Antonia Noori Farzan, Jennifer Hassan, Paulina Firozi, Adam Taylor, Paulina Villegas and Hamza Shaban, November 20, 2020. https://www.washingtonpost.com/nation/2020/11/19/coronavirus-covid-live-updates-us/, accessed 25 November 2020.
2 COVID-19 CORONAVIRUS PANDEMIC, November 24, 2020, 2020, https://www.worldometers.info/coronavirus/?utm_campaign=homeAdvegas1accessed, accessed 25 November 2020.
3 Quantitative easing, or QE as it’s better known, is a policy in which central banks like the Reserve Bank of Australia, the US Federal Reserve, and the Bank of England, buy financial assets, such as government bonds from the open market to encourage lending and investment.
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