How do we invest in an inflationary environment?

In this series, our Old Mutual Wealth Investment Managers answer some hard questions and demonstrate how they do the hard thinking and work so that you don't have to. Their answers are based on an in-depth understanding of the local and global economy, financial markets, and the driving forces that will shape tomorrow.

Andreea Bunea, Head of Global Equity at Old Mutual Multi-Managers talks about what the landscape would look like in terms of global inflation.

For more information visit:
https://www.oldmutual.co.za/wealth/hq-investment/

Chapters

• 0:02 Introduction to the Hard Questions series.
• 0:46 Introduction to the topic and speaker.
• 1:26 How did we get to where we are with global inflation?
• 4:45 How did an under investment in commodities come about before geopolitical crises like the war in Ukraine?
• 6:44 How investors deal with inflation, and the importance of understanding how different asset classes perform in an inflationary environment.
• 11:52 What kind of companies do well in a high inflationary environment?
• 14:29 What does Andreea expect to happen in terms on inflation in the next year?
• 15:44 Conclusion.

Transcript

Old Mutual  00:02

Investing your wealth is a journey that demands skill, in depth knowledge, experience, and conviction from the investment manager. From you, the investor, it demands time, patience, and trust in your investment manager's ability. While investing is certainly rewarding, it can be complex. You will have questions along the way, and we're here to help you find the answers. 

In this series, our Old Mutual Wealth Investment Managers answer some hard questions and demonstrate how they do the hard thinking and work so that you don't have to. Their answers are based on an in-depth understanding of the local and global economy, financial markets, and the driving forces that will shape tomorrow. 

Ian Fraser  00:46

Welcome to the podcast, everybody. It is great to have you listening and welcome from myself, Ian Fraser. We're talking today about what the landscape will look like in terms of global inflation. And how on earth did we get here? I've got a couple of ideas, but we might be able to find out a lot more from our guest today. 

Andreea Bunea is our guest from Old Mutual. She's going to be talking to us with regard to inflation, from Old Mutual Multi Managers in the investment team. Andreea, first of all, welcome to you. Great to have you on the podcast today. How's it going?

Andreea Bunea  01:21

Hi, Ian. Hello, very well, thank you. Good to be here.

Ian Fraser  01:26

Yeah, it's good to have you here. My ears are open. And I have no doubt that everybody else listening has a moment or two to spare to find out more about global inflation. It's something we can't get away from. And I'd love to know, in context, a bit more about it, and how we got to exactly where we are today. Let's start high level on a global kind of view of the whole thing. Tell us more about how we got to where we are when it comes to global inflation.

Andreea Bunea  01:56

So, as you pointed out, Ian, we're currently dealing with very high levels of inflation on a global scale. For instance, at the moment, we are seeing inflation rates of 8.5% in the US year on year. And even in Europe, we're seeing inflation rates of seven and a half over the last 12 months. These are certainly levels, fairly elevated levels of inflation that we haven't seen in the last 40 years or so. 

There certainly are a number of factors that have, I think, collectively contributed to the current high levels of inflation. So, on the one hand, we have very strong pent up consumer demand for goods, as you know, the pandemic continued to wane. And this was also boosted by aggressive expansionary monetary and fiscal policies in response to Covid, particularly amongst developed economies. Ultimately, this has left consumers in those economies with a lot of excess savings to spend, which they have certainly done once the pandemic lockdowns eased. At the same time, when consumer demand was surging, supply was also being constrained. Particularly for large businesses with complex supply chains, as their production tends to be very vulnerable to such disruptions. 

So, those were some of those sort of earlier pressures on inflation. But of late, we're quite aware of Russia's invasion of Ukraine. And this event, a geopolitical event, has also placed further upward pressure on commodity prices, particularly food and oil. At the same time, there were further disruptions to the supply chains, so ongoing disruptions to those global supply chains experienced across many businesses around the world. And the latest bout of supply chains being brought about by lockdowns in China or the latest lockdowns in China as a result of a resurgence in Covid infection cases. 

So, all of these developments over the last two years or so, have created this perfect storm of pressures on prices, which have led to the current elevated levels of inflation. What this also has meant is that these developments also point to inflation remaining at elevated levels for longer than previously anticipated. So, I hope that gives you a good flavour or a good picture as to how we got to this point. 

Ian Fraser  04:45

Andreea, can I just rewind for a second. We've spoken commodities now, you've mentioned the obvious ones like cooking oil, because of Ukraine being one of the biggest suppliers in the world, commodities, etc. from that point of view. Why was it that before all of these sort of geopolitical crises occurred, etc, there was such an under investment in commodities. Was it that people scrambled to get into commodities after this crisis to be able to kind of find a safe haven? Was it a bit more stable? I'm just interested in that.

Andreea Bunea  05:17

That's an interesting question, Ian, and thank you for that. I think the under investment in commodities, and here again, we're talking more about the resource-type commodity, so those that need to be extracted out of the ground, so not necessarily agricultural products as such. From an oil or fuel perspective, what has led to the pressures on - upward pressures on prices has been the fact that OPEC hasn't really propped up production in response to the increase in demand as the lockdowns continue to ease into 2020. So, that is one of the reasons. 

Other commodities such as coal, iron, copper, etc. there has been an under investment in those commodities, particularly over the last decade or so, as we've seen, the prices for those major commodities really coming under pressure post really favourable commodity cycle in the early noughties. So, it was really a wave of under investment that has led to the supply constraint where we find ourselves today in the light of increase in demand for these type of commodities. Obviously, the type of supply that needs to come on board hasn't been fast enough to sort of meet that.

Ian Fraser  06:44

Okay, thanks. That's a comprehensive answer for me. Let's get back to the topic of inflation, because that's where we were headed, and I steered you down a little side road there. I want to find out about investors and having to deal with inflation. That kind of makes investors' lives a bit more difficult, doesn't it, Andreea?

Andreea Bunea  07:01

It does but understanding how different asset classes perform in an inflationary environment is quite important for investors. These will ultimately drive returns for investors during such an environment, but it also gives them an opportunity to understand what type of asset classes not to be tilted towards, should those type of asset classes not be expected to benefit in this type of environment. 

So, for instance, from an asset class perspective, bonds are normally the biggest losers in this environment. And we've seen how global bonds have been impacted over the last 12 months, having registered, in fact, one of the worst years on record. As you saw, yields, global yields increased sharply across the board. 

Now, in South Africa, the experience of our bond market was somewhat different, as local yields were already quite elevated coming into this current environment, while at the same time, our inflation outlook has not fundamentally worsened when compared to the past. And this is quite a different picture to what we've noticed, for instance, in the US and Europe, where that inflation outlook has gotten worse over the last six months or so. 

08:27

Also, in this type of environment, cash can be a fairly useful asset. But ultimately it depends on how quickly the central banks are going to push up those interest rates. In most countries, as it stands at the moment, interest rates are quite well below the current inflation rates. So , from a real return perspective, cash is not necessarily very attractive. For instance, in South Africa, the repo rate is currently at 4.25, with inflation rates at about 6%. You're certainly not tweaking out or you're not able to get out a real return from that asset class. Commodities also, for instance, tend to be quite good inflation hedges that have historically performed well in an inflationary environment. And this is one of the reasons why perhaps South African equities have actually done so well over the last couple of months. On the back of that upward pressure and commodity prices which has obviously supported many, many commodity or resource type companies that are currently listed on the local boards. 

09:42

Property, again, is also another asset class that is a good inflation or acts as a good inflation hedge. And this is predominantly because the rental income that's being charged by landlords tends to increase with the inflation over time. On the other hand, obviously, the cost pressures from a building and maintenance perspective are likely to be a drag on income for those type of companies. It's also worthwhile pointing out that property sectors in the local space is current is quite different to what we have available globally. 

So, in the local space, large parts of the property sector, such as shopping malls and office buildings, have still not recovered yet from Covid. That's still sitting with very large vacancies. And also, in such instances, landlords' ability to increase rent is diminished, it's very much reduced. And this is because tenants, at the end of the day, do have the ability to move to alternative buildings if they're not necessarily happy with the rental increases. And buildings or property, such as shopping malls and office buildings, etc. makes up quite a large component of our local property sector. 

Now, globally, the property sector is a lot more diversified. And there are, for instance, sectors such as data centres that are benefiting from this global shift to working and shopping online. There is also the residential sector, which continues to sort of benefit from the shift to work from home environment. So, the fundamentals of the global property sector are a lot more attractive, compared to, for instance, the local counterpart.

Ian Fraser  11:52

Very interesting. Let's talk about that. Let's pick up a bit more about that when it comes to doing well, certainly when it comes to companies. What kind of companies can then do well in the environment of high inflation and sort of the situation that's happening at the moment, in certainly the first world?

Andreea Bunea  12:12

Ja. So, that's a very good question. As I mentioned, there's certainly various asset classes that from a broad perspective, they may benefit or be hurt in the current inflationary environment, but also within those asset classes, there are companies or sub-sectors that could ultimately be beneficiaries and others that are also going to be hurt, even though the asset class itself may, overall, benefit. 

So, if we look at equities in general companies with pricing power are in a good position to benefit in the current inflationary environment. For instance, companies with a strong brand tend to have pricing power, as customers tend to remain quite loyal to their specific brand, even in cases where prices of the products or the services that they sell may increase. 

Another example of pricing power would be, for instance, companies that offer products or services that are differentiated from their competitors. And also require for instance, constant innovation and updates. And examples of that would be, for instance, Apple, or, you know, Microsoft. So, those individuals who do use Apple type products, they're probably quite loyal to the brand and they tend to prefer using that complete ecosystem that allows them to use different Apple devices at the same time. So, that brand loyalty, essentially supports the pricing power of those companies and supports their ability to continue to pass on increases in input costs on to consumers without necessarily losing a lot of their consumer base. So they're in a better position to absorb those price increases, bypassing those increases, ultimately, on to their own customers, whether those customers, ultimate customers, are the businesses or ultimately the end consumer.

Ian Fraser  14:29

I'm gonna ask you a left-of-centre question here to wrap up in terms of global inflation. When you look into your crystal ball in front of you there, I can see it and you can rub it and give me an answer here. What do you think's gonna happen in terms of inflation in the sort of next year or so?

Andreea Bunea  14:43

So, as it stands, inflation is likely to be a little bit lower. Obviously, there's a lot of basic facts that are still coming through. So, in other words, the high increases in commodity prices that we've seen over the last 12 months have come off a very low base. So, the expectation of similar price increases in commodity prices going forward over the next 12 months are probably unfounded. 

However, at the same time, it's worth pointing out that inflationary pressures will probably continue to exist in the system as supply chain disruptions are probably going to take quite a while to unwind. So, going into next year, we certainly don't expect - or I won't expect inflation rates of similar levels of around 7 to 8% globally, those are likely to come down, but they are probably going to be still higher than what we've been used to up until now.

Ian Fraser  15:44

Right. Good answer. And thank you, sorry for me putting you on the spot there. But that is an interesting perspective, from your point of view. And to hear it as well from our point of view. Just to timestamp this, if you are listening to this in the next few months, we are at the end of April. So, that's kind of where we're pegging this information right now while we do this podcast. I think we leave it there. That is a very good insight. 

Thank you, Andreea Bunea, Old Mutual Multi Managers investment crew, who are on the podcast today. Andreea, thanks for your time. Thanks for your insights. We really appreciate it.

Andreea Bunea  16:17

You're welcome. Thank you for having me.

Old Mutual  16:20

Old Mutual Wealth is a world class investment destination, offering you a wide range of investment strategies and specialist wealth management solutions. Whether your goal is to grow your wealth, generate income, or preserve capital, we select the best and most suitable investments based on your investment strategy and our extensive research and collective insights. It's vital to work with reputable specialists who can effectively structure an investment portfolio that is tailored to your unique needs and objectives. Email us at hardquestions@omwealth.co.za, so that we can help you take your wealth further.