Investment Insight | Reflation reversal? Thinking long term.
In early June we discussed inflation rising to levels not seen for over 35 years. This ‘reflation’ theme lifted the prices of shares and commodities to record highs. Economically-sensitive shares were good, while bonds, big bond-like shares and those that react strongly to interest rate increases (including technology companies) were bad.
Yet for the past few months, the exact opposite has been the case. Since June, investments that benefit from higher inflation made a sudden downturn following the hawkish announcement from the Federal Reserve. Gold and Bitcoin sank, the yield curve flattened aggressively (i.e., interest rates decreased), inflation expectations collapsed, the United States dollar rallied, industrial metal and agricultural commodities plunged, and financial and energy shares underperformed
This reflation reversal is the key driver of our underperformance over the past few months. We are disappointed that clients have seen their portfolios reduce in value, especially after such a strong period of outperformance. While negative performance is frustrating, when we look at the causes and assess the investment regime we are moving to, we remain incredibly excited about the opportunities to generate strong returns.
For now, we have significantly reduced clients’ exposure to the reflation theme and have increased exposure to more defensive sectors such as large tech companies (see 16 July 2020 | Famous Five).
Why? There is an idea that high rates of inflation may force the Federal Reserve to hike interest rates prematurely, curbing future growth. There is also a fear that the spread of the Delta COVID-19 variant might disrupt the global economic recovery. Finally, there are concerns that policy changes and slowing growth momentum could undermine sentiment on China. Markets right now are jittery, and we have taken a step back.
Is the reflation trade over?
We think fears about early Federal Reserve interest rate tightening, COVID-19 variants, and slower growth will abate and interest rates will rise. Thus, the share market rally – which we believe has further to run – will eventually be driven by the reflation beneficiaries, retracing the recent negative performance. We are stalking the market for key datapoints and when we see evidence of a recovery in the reflation beneficaries, we will re-enter these positions.
Our Approach
Traditionally, New Zealand fund managers have focused on listed shares and bonds (and recently, private equity). This is consistent with a developing and relatively unsophisticated financial market. In the more mature, self-directed retirement savings markets of the United States, United Kingdom and Australia, managers use the additional asset classes of alternative assets (hedge funds), currencies and commodities to increase diversification.
NZ Funds believes that an approach which seeks to add value to a core asset class exposure (for example, shares) through tilting to a wide and diversified range of globally recognised, highly liquid assets has the potential to add value.
There are risks with owning and/or tilting to additional asset classes in a diversified portfolio, just as there are risks associated with investing in shares and bonds, meaning risk management is fundamental. Over the last 30 years, NZ Funds has developed a series of risk management tools designed to mitigate the possibility that retail investors suffer a permanent loss of capital. The recent negative performance, while disappointing, is not extraordinary. We believe that listed shares and bonds are central to long-term investing. But in line with global norms, New Zealanders should benefit from access to additional asset classes and investment techniques. Without this, our investors would be at a disadvantage compared with investors in many overseas retirement savings markets.
Looking forward, we believe that over the next 12 to 18 months client portfolios are positioned to generate strong returns. The global economy is embarking on a huge structural change, especially in bond markets where for the first time in over 10 years we expect to witness sustained inflation and interest rate rises. We must just be patient.
Yet for the past few months, the exact opposite has been the case. Since June, investments that benefit from higher inflation made a sudden downturn following the hawkish announcement from the Federal Reserve. Gold and Bitcoin sank, the yield curve flattened aggressively (i.e., interest rates decreased), inflation expectations collapsed, the United States dollar rallied, industrial metal and agricultural commodities plunged, and financial and energy shares underperformed
This reflation reversal is the key driver of our underperformance over the past few months. We are disappointed that clients have seen their portfolios reduce in value, especially after such a strong period of outperformance. While negative performance is frustrating, when we look at the causes and assess the investment regime we are moving to, we remain incredibly excited about the opportunities to generate strong returns.
For now, we have significantly reduced clients’ exposure to the reflation theme and have increased exposure to more defensive sectors such as large tech companies (see 16 July 2020 | Famous Five).
Why? There is an idea that high rates of inflation may force the Federal Reserve to hike interest rates prematurely, curbing future growth. There is also a fear that the spread of the Delta COVID-19 variant might disrupt the global economic recovery. Finally, there are concerns that policy changes and slowing growth momentum could undermine sentiment on China. Markets right now are jittery, and we have taken a step back.
Is the reflation trade over?
We think fears about early Federal Reserve interest rate tightening, COVID-19 variants, and slower growth will abate and interest rates will rise. Thus, the share market rally – which we believe has further to run – will eventually be driven by the reflation beneficiaries, retracing the recent negative performance. We are stalking the market for key datapoints and when we see evidence of a recovery in the reflation beneficaries, we will re-enter these positions.
Our Approach
Traditionally, New Zealand fund managers have focused on listed shares and bonds (and recently, private equity). This is consistent with a developing and relatively unsophisticated financial market. In the more mature, self-directed retirement savings markets of the United States, United Kingdom and Australia, managers use the additional asset classes of alternative assets (hedge funds), currencies and commodities to increase diversification.
NZ Funds believes that an approach which seeks to add value to a core asset class exposure (for example, shares) through tilting to a wide and diversified range of globally recognised, highly liquid assets has the potential to add value.
There are risks with owning and/or tilting to additional asset classes in a diversified portfolio, just as there are risks associated with investing in shares and bonds, meaning risk management is fundamental. Over the last 30 years, NZ Funds has developed a series of risk management tools designed to mitigate the possibility that retail investors suffer a permanent loss of capital. The recent negative performance, while disappointing, is not extraordinary. We believe that listed shares and bonds are central to long-term investing. But in line with global norms, New Zealanders should benefit from access to additional asset classes and investment techniques. Without this, our investors would be at a disadvantage compared with investors in many overseas retirement savings markets.
Looking forward, we believe that over the next 12 to 18 months client portfolios are positioned to generate strong returns. The global economy is embarking on a huge structural change, especially in bond markets where for the first time in over 10 years we expect to witness sustained inflation and interest rate rises. We must just be patient.
Source: Bloomberg, NZ Funds calculations.
For more information please contact NZ Funds.
This document has been provided for information purposes only. The content of this document is not intended as a substitute for specific professional advice on investments, financial planning or any other matter.
While the information provided in this document is stated accurately to the best of our knowledge and belief, New Zealand Funds Management Limited, its directors, employees and related parties accept no liability or responsibility for any loss, damage, claim or expense suffered or incurred by any party as a result of reliance on the information provided and opinions expressed except as required by law.
For more information please contact NZ Funds.
This document has been provided for information purposes only. The content of this document is not intended as a substitute for specific professional advice on investments, financial planning or any other matter.
While the information provided in this document is stated accurately to the best of our knowledge and belief, New Zealand Funds Management Limited, its directors, employees and related parties accept no liability or responsibility for any loss, damage, claim or expense suffered or incurred by any party as a result of reliance on the information provided and opinions expressed except as required by law.
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James Grigor is Chief Investment Officer for New Zealand Funds Management Limited (NZ Funds) and a member of the NZ Funds KiwiSaver Scheme. James' comments are of a general nature, and he is not responsible for any loss that any reader may suffer from following it.
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