In a polarised world, valuations can move to extreme levels and sentiment can swing to the extent that one hears fund managers claim they will ‘never own’ a particular asset, sector or factor. Equally, extreme crowding into certain themes or characteristics can narrow market breadth into an extremely small group of companies. That creates pricing anomalies in a world which is more nuanced.
In the case of the inflation debate, we believe we are being paid to own some assets that do well in an environment where inflation is more apparent simply because for so many years they have been priced as though it would never occur. This does not mean abandoning every long duration asset nor making a one-sided factor call – but does lend itself at the very least to more balance than has been evident in markets since 2008.
The polarised view had come to correlate entire sectors almost perfectly to the 10-year Treasury yield whereas the recent earnings season revealed a huge range in management teams’ abilities to cope with higher cost bases. Long duration assets are more vulnerable to upward shifts in discount rates so whilst those companies that can continue to grow and deliver cash and earnings can remain market stalwarts, the risks associated with non-profitable concept stocks may increase. Equally, sectors that had been regarded as generically ‘un-investible’ in an era of ever lower rates (such as financials, energy and short-cycle industrials) and aggressively de-rated now have strong and weaker players within them priced with relatively little differentiation. That is fertile ground for active managers.
We have been in a market regime where a particular asset quality/style has been dominant – most simply summarised as long duration – and best encapsulated by the technology space where excellent company fundamentals were combined with ever lower discount rates in a low growth low inflation post GFC era. Valuations adjusted accordingly to a point where the probability of inflation was almost entirely priced out. There is now a healthy debate as to whether that era is changing, and the ramifications of that debate argue for a more diversification across client portfolios. The good news is that the areas of the equity market that show a positive linkage to inflation remain some of the most attractively priced in the market. Investors are being paid to put balance in their portfolios. The debate on the risk of inflation may be polarised but portfolio exposure need not be.