Investments to defend against higher inflation and slower economic growth

Central Banks around the world are removing highly accommodative levels of near zero interest rates and are raising official cash rates in response to a rising inflationary environment – which is a function of higher wage expectations as well as higher fuel, food and housing costs. The irony is that much of the inflation that is in place is a consequence of central bank emergency policies, which provided excess liquidity to financial markets and funded government expenditure programs which supported household consumption over the last few years.

Higher inflation and interest rates are negative for financial markets and asset prices as higher inflation reduces the real value of cashflows and is a drag on corporate profitability, and higher interest rates reduce asset valuations through reduced present value of future cashflows. Higher rates also stymie household consumption, which results in slower economic growth. The combination of higher inflation and lower growth is challenging for policy makers to solve, and for financial assets.

A slowing global economy going forward must be put in context of the last few years, which saw extremely elevated economic growth and strong double digit returns for global share markets. We have previously flagged that after such a strong performance in recent years it was likely that forward returns would be much more modest and for investors to recalibrate their expectations accordingly.

That said, there are a range of strategies within different asset classes that can help protect portfolios, and to ride out a period of higher inflation and slower economic growth, which we outline below.

Where are the Opportunities?

Equities (Shares)

Essential products and services companies that operate as market leaders which can control their prices against rising costs are the most effective way to hedge inflation risks. These companies can be found across a range of sectors, including Technology, Healthcare, Materials and Utilities. Sectors that we are cautious on include Consumer Discretionary and Financials, which are negatively impacted by slowing household consumption and slowing credit growth.

The Technology sector has been one of the hardest hit from the recent market volatility due to the negative sensitivity of valuations to rising interest rates, but in our view remains fertile for new investment opportunities. Technology valuations are the most attractive they have been in several years, and high-quality companies have been indiscriminately sold down along with lower quality speculative businesses. For example, two of the global tech leaders, Microsoft (-24% year to date) and Alphabet (-23% year to date), have demonstrable pricing power and provide essential products and services with few competitors across software, cloud, and search. In the recent quarterly updates these two companies posted sales growth of 18% and 26% respectively, and both are highly profitable. Despite their size these companies continue to generate strong growth, which demonstrates the truly staggering size of their end markets.

Healthcare is an essential services sector with some of the best quality and more defensive companies on the planet, that are both highly cash generative and recession proof. Examples of companies in our portfolios include medical devices and pharma leader Johnson & Johnson, local biopharma favourite CSL and diabetes pharmaceutical leader Novo Nordisk.

Novo Nordisk is a prime example of a “defensive” company, as life-supporting diabetes treatment is the opposite of a discretionary purchase, and it is one of the key players in insulin with around 30% of the global market. This is evident in its financial results:  whilst earnings growth slowed during the global financial crisis (GFC) and Covid pandemic it has not gone backwards during the last 20 years. In contrast, at the trough of the GFC the average S&P 500 company earnings declined by 30% and during Covid declined by 16%.

The less “racy” parts of the share market really shine during slower growth periods as investors flock to the greater earnings stability and dividend income streams. We have several of these types of companies in our portfolios, including domestic supermarket leader Woolworths, global packaging company Amcor and gas pipeline operator APA Group. The revenue streams of these businesses are non-cyclical and rising costs can be passed through to their customers, which protects their profit margins during slower growth and higher inflation environments.

Bonds (Fixed Interest)

The good news from rising interest rates is that the yield on fixed income securities such as Bonds are rising too. For example, an index that tracks a diversified exposure to Australian Bonds, the Core Composite Bond Index, is currently paying a yield of over 3%. This compares favourably to 12 months ago, when the index was paying a yield of less than 1%.

An interesting situation is developing in financial markets, with investors pricing in interest rates of greater than 3% against economist predictions which are for less aggressive interest rate hikes, ranging from 1.5% to 2.5%. The economists’ arguments are that the economy, specifically the household sector, cannot deal with rates of above 3% due to over indebtedness. As always, we think the truth lies somewhere in the middle – which means that bond investments could deliver positive capital gains plus a 3% income yield to investors over the coming year.

Infrastructure

The infrastructure sector contains many defensive companies with regulated and recurring revenue streams that have embedded inflation protection, including utilities and pipeline assets. These types of assets generate sustainable dividend yields and cashflow streams that are more resilient during periods of slower economic growth – making them an ideal ballast for portfolios during volatile market conditions. The sector also has growth characteristics that will benefit as economies reopen from COVID-19 and consumers shift from goods to services – which benefits infrastructure companies operating toll road and airports. Our preferred investment exposures in the infrastructure asset class are active manager ATLAS Infrastructure and Vanguard and Van Eck Infrastructure Exchange Traded Funds (ETFs). This combination of active and passive provides potential for excess returns from an active fund as well as efficient low-cost exposure to the sector from the passive ETFs.

Property

Property valuations tend to decline during recessions, although there are mitigating factors such as inflation protected rental escalations and non-discretionary nature of many parts of the real estate universe. To that end, the Australian real estate investment trust (REIT) sector has declined by 17% year to date.

Within the property sector there are a range of assets that exhibit defensive characteristics such as essential services such as healthcare, childcare, neighbourhood shopping centres, petrol station convenience sites, supermarket distribution centres and government office properties. The other characteristic of many property assets is the embedded rental inflation mechanism, which protects investors from elevated levels of inflation.

Our View

Examples of REITs that meet these types of characteristics include Charter Hall Long WALE REIT (CLW), HealthCo Healthcare and Wellness REIT (HCW) and RAM Essential property (REP) – all of which are paying income yields of over 4.5%, own non-cyclical defensive property assets, have long lease expiry schedules and are operating with full occupancy levels.

If you wish to discuss any concerns about the current market or about any strategies to do with your financial plans, do not hesitate to call your Financial Adviser.