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Boutique insights: Who's afraid of inflation?

Are local boutique managers more worried about inflation or deflation, and what are they doing to protect their portfolios? Citywire spoke to four balanced fund managers to find out.

Inflation rates in most countries around the world have fallen sharply in the Covid-19 crisis. South Africa has printed its lowest inflation rates in decades over the past two months.

It is understandable that the combined supply and demand shock that has come from shutting down economies is inherently deflationary. The concern that some market participants have is that this could perpetuate.

Demand may recover more slowly than supply, driving prices lower. Companies being propped up by stimulus could also afford to run at a loss and cut prices even further to try to attract revenues. 

Yet, at the same time, the amount of fiscal and monetary stimulus being delivered into the economic system is creating fears of inflation. With governments taking on huge amounts of debt, there is also the potential that inflating it away is the only viable option they will have to manage it.

How do fund managers navigate an environment in which these two, opposing scenarios are both possibilities?

Citywire spoke to four local boutique balanced fund managers about how they are approaching this conundrum. Their divergent responses were fascinating.

Click through the slides to read their views.

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Inflation rates in most countries around the world have fallen sharply in the Covid-19 crisis. South Africa has printed its lowest inflation rates in decades over the past two months.

It is understandable that the combined supply and demand shock that has come from shutting down economies is inherently deflationary. The concern that some market participants have is that this could perpetuate.

Demand may recover more slowly than supply, driving prices lower. Companies being propped up by stimulus could also afford to run at a loss and cut prices even further to try to attract revenues. 

Yet, at the same time, the amount of fiscal and monetary stimulus being delivered into the economic system is creating fears of inflation. With governments taking on huge amounts of debt, there is also the potential that inflating it away is the only viable option they will have to manage it.

How do fund managers navigate an environment in which these two, opposing scenarios are both possibilities?

Citywire spoke to four local boutique balanced fund managers about how they are approaching this conundrum. Their divergent responses were fascinating.

Click through the slides to read their views.

 

Andrew Vintcent - Co-portfolio manager of the ClucasGray Equilibrium Prescient fund

 

Are you more worried about the possibility of inflation or deflation, and how is this reflected in your portfolio?

The Covid-19 crisis has resulted in the global economy experiencing the most severe economic downturn in living memory. This has simultaneously been met with the most aggressive fiscal and monetary policy response in history.

Globally, weak near term demand and the fear of deflation, places central banks medium-term inflation targets at risk. The response has been designed to stave off deflation, with central banks seemingly prepared to embrace the risks of elevated inflation in due course, and act accordingly.

In South Africa too, the economic devastation caused by lockdown has resulted in a weak demand backdrop. Supply-side inflationary pressures from a weak rand or elevated administered prices are currently offset by a lack of demand.

Whilst mindful that lockdowns will end in due course, and that interest rates have been significantly reduced, our central view is that we are in an environment of contained domestic inflation in the near term. We expect core CPI to remain within the target range.

The ClucasGray Equilibrium Fund adopts a dynamic approach to asset allocation and security selection, identifying investment opportunities which are able to deliver real growth in earnings at attractive valuations, or real income yields.

Given the benign inflation outlook, South African interest rates are at multi-decade lows, yet longer duration bond yield remain elevated. We view South African bonds as attractive, given the real yields on offer, as well as the yield relative to global bonds.

Equities have traditionally benefited from modest inflation. We believe global equities should see reasonable earnings growth in a reflationary environment, and although certain valuations are stretched relative to history, select global equities are appealing.

Reflation of the global economy has typically been supportive of commodity demand, and we have a large position in resource companies, which will benefit from an improving economic backdrop.

Finally, moderate inflation, and low interest rates have historically been supportive of the domestic economy. Coupled with attractive valuations in many domestic companies, we feel it appropriate to be exposed to South African equities. 

 

Roger Williams - CIO an manager of the Centaur BCI Balanced fund

 

Are you more worried about the possibility of inflation or deflation, and how is this reflected in your portfolio?

Steve Hanke, the world’s pre-imminent authority on hyperinflation, said recently:

‘The underlying causes of inflation are always the same. Governments start running larger and larger fiscal deficits and call on the central bank to fund those deficits because tax and bond financing avenues are inadequate. In hyperinflations, central banks are required to virtually fund the government’s entire fiscal operations.”

Is this not where South Africa is heading?

Centaur Asset Management is preparing for the eventuality of higher inflation by investing in rand hedges, high quality South African equity hedges and inflation-linked bonds whilst reducing exposure to poor inflation hedges like cash and nominal bonds.

The Centaur BCI Balanced Fund is transitioning towards a higher inflation scenario with high offshore exposure (at the 30% regulatory maximum), reducing exposure to local government bonds, switching South African stocks towards inflation hedges and targeting inflation-linked bonds.

Centaur sees an asymmetric pay-off on this positioning. If we are wrong, the portfolio will deliver solid returns, but if our view is correct we will successfully protect our clients hard-earned investment monies from the devastating effects of inflation.

 

Walter Aylett - Manager of the Aylett Balanced Prescient fund

 

Are you more worried about the possibility of inflation or deflation, and how is this reflected in your portfolio?

When asked about any macro-economic indicator such as a forecast on inflation, our initial response is to swiftly select the too-tough tray. Our record as bottom-up investors has been poor in this regard and we prefer to select assets which will produce income in real terms.

We believe assets that, regardless of any inflation scenario, produce real income at the right valuation will more than adequately compensate us as investors.

That is not to say we do not think about inflation.

As matters stand now, it feels like we will have inflation going forward. Electricity costs are expected to increase by 15% next year, significantly ahead of inflation. Municipal rates will increase by higher than usual – and the usual increase is already ahead of total inflation.

Public servants continue to ask for more than inflationary increases, which filters throughout all administered costs in the economy. The weak rand will also further filter into higher costs locally for consumers.

Incompetence and corruption within government spending will continue to lead to higher prices and ultimately higher taxes such as VAT and excise duties. The end result is increasing interest rates. 

The long-term impact of importing deflation from Asia is also coming to an end and therefore we need to use a higher discount rate to value assets in South Africa.

In conclusion, assets that have great cash flow yields, strong balance sheets, excellent management and pricing power will compensate us for a higher inflation environment. In the absence of an economic recovery, we feel that companies such as Bowler Metcalf, Transpaco, the platinum producers, AECI and Hudaco will do just fine.

 

Abri du Plesses - Co-portfolio manager of the Gryphon Prudential fund

 

Are you more worried about the possibility of inflation or deflation, and how is this reflected in your portfolio?

Inflation is the harsh reality that erodes the buying power of an investor’s capital over time. From a monetary point of view, inflation determines the level of interest rates.  Interest rates, and particularly the yield gap (long rates minus short rates), play an integral part in Gryphon’s investment process in that they provide valuable insights into the business and investment cycles.

The business cycle is the sole driver of the asset allocation process of the Gryphon Prudential fund. The over-arching purpose of the fund is to preserve clients’ capital, and then to generate returns which grow the real wealth of investors. Thus, determining prospective inflation and deflation is an integral part of our investment process.

Rising and volatile inflation impacts the discount rate of future cashflows, and investors may no longer be prepared to pay as much for these future (more volatile) cashflows. Thus equity return expectations  should be tempered.

For South African investors, if inflation picks up dramatically, the underlying commodity-based economy is likely to sustain economic activity and thereby provide opportunities for local investors. Further, should global deflation prevail into the future, precious metals prices are likely to remain elevated and these are also likely to support local economic activity.

Because South Africa’s inflation rate is higher relative to developed economies, our real interest rates are also likely to remain higher, providing an opportunity for greater returns from cash and/or bonds.

Given current market uncertainty and volatility, the Gryphon Prudential fund has zero exposure to equities and we will take advantage of other asset classes, namely bonds and cash (both local and offshore).

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Related Fund Managers

Abri Du Plessis
Abri Du Plessis Average Total Return:
39.38%
13/92 in Mixed Assets - Flexible ZAR (Performance over 3 years)
Roger Williams
Roger Williams Average Total Return:
13.81%
63/92 in Mixed Assets - Flexible ZAR (Performance over 3 years)
Andrew Vintcent
Andrew Vintcent Average Total Return:
-15.39%
91/109 in Equity - South Africa (Performance over 3 years)
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