After last week’s shock consumer price index (CPI) saw inflation rise 1.3 per cent in the September quarter, investment director at the private equity firm, Justin McLaughlin, has argued investors may once again need to consider how to manage inflationary risks within portfolios.
Writing in a recent note, McLaughlin noted the complicated combination of inflationary drivers currently at play, with risks centering on the disruption of global supply chains and excessive fiscal expansion.
“Some of the structural deflationary forces that have shaped recent decades, such as globalisation, are now clearly reversing. Rising tariff barriers and trade disputes are emerging between major economic blocs,” he said.
Adding to this, he highlighted ongoing debt concerns in the US: “When confidence in a country’s currency and its monetary and fiscal authorities is shaken, the result is often higher inflation.”
While he conceded that predicting when inflation would worsen is often difficult, in these circumstances, he said investors often turn to real assets as a source of protection.
He argued real assets are attractive for two main reasons.
First, they hold tangible value: they are “hard” assets with intrinsic worth and utility – such as property, infrastructure, gold and commodities. And second, they provide inflation-linked income, that is, income streams that typically rise with inflation.
On the other hand, he argued equities do not serve as appealing inflation hedges, despite corporate earnings and dividends being variable and capable of increasing with inflation, unlike bonds.
According to McLaughlin, the issue here lies in the negative revaluation impact which is frequently observed during periods of elevated inflation and increasing interest rates.
“While company earnings may adjust upward, equity valuations tend to decline as discount rates rise. The result is that the de-rating effect on valuations in inflation periods typically outweighs the inflation pass-through benefits from earnings growth,” he said.
Benwerrin
McLaughlin’s comments come as the firm recently launched Benwerrin, a specialist investment manager focused on metals and mining, reportedly seeking to meet investor demand for real assets.
The new venture was formed in partnership with five founding executives, as reported by Money Management, InvestorDaily’s sister publication, with Benwerrin providing project debt financing to the mining and commodity-related sectors.
According to Scarcity, it is the commodity-linked cashflows – such as royalties and streams – that gives the portfolio its positive relationship and correlation with rising levels of inflation. The firm argued that commodities, along with inflation-linked bonds, have historically proven to be among the most effective assets for safeguarding investor capital during times of inflation.
Royalties investing, an asset class still largely misunderstood and under-represented in the domestic market, saw a September record $6.7 billion flow into music-backed debt on Wall Street this year.
This publication has previously examined the advantages and disadvantages of this asset class, finding that while it can deliver on diversification, its unclear nature presents scaling challenges.
Speaking to InvestorDaily at the time, Betashares investment analyst Tom Wickenden pointed out that royalty revenues can in fact offer a dual advantage against inflation.
“They can benefit from both rising prices and are less exposed to input cost inflation, providing protection in inflationary environments,” he said.
At the same time, McLaughlin admitted that structuring inflation protection within a portfolio can be “surprisingly challenging”.
For example, while infrastructure and property investments often feature cash flows contractually tied to CPI, they are susceptible to substantial drops in capital value during periods of high inflation or interest rate volatility, which can largely negate the benefits.
He concluded that a typical 60/40 portfolio has substantial inflation-related risk, especially in its fixed income and equity exposures.
“With the current macroeconomic backdrop, now appears to be an opportune time for investors to think laterally about integrating real assets and inflation-linked exposures into their portfolios.”
