Potential portfolio impacts of a rising rate or inflationary environment — international equity
February 1, 2013
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Edward A. “Ned” Gray, CFA
Senior Vice President, Chief Investment Officer — Global and International Value Equity
One of the major constraints on the recovery overseas has been deflationary pressures, which have manifested themselves in a variety of ways, but particularly in the slow growth of credit. So, we believe investors would welcome a modest pickup in inflation, as long as it was associated with rising expectations for economic growth. But if inflation does revive, the devil will be in the details. In other words, how much of an increase in prices will we see, and over what time period will it occur? The markets can adjust to a modest and gradual increase in consumer prices, and may even respond more preferably in such an environment,
compared to the borderline deflationary pressures that are now in place.
The exception to that would be China, which deliberately slowed its economyto keep inflationary pressures in check. Overall, however, international markets(most notably Japan) have been struggling with borderline or outright deflation for so long that any hint of an increase in inflationary pressure would be greeted with tremendous enthusiasm, in our opinion. In fact, we’ve already begun tosee that. In the fourth quarter of 2012 — a period in which it appeared that political changes in Japan might finally spark a decisive response to the deflation problem — there was a 55-percentage-point return differential between the highest-and lowest-risk stocks. Since each sector of the international equity market is at a different point relative to its inflation cycle, though, we are sensitive to the need to look at each region and each company on an individual basis. (Source: Bloomberg.)
Vice President, Senior Equity Analyst — Emerging Markets
Inflation and rising rate scenarios are something that we generally stay very cognizant of, particularly in this environment, since we believe there is a very good possibility that the super-easy monetary policy in the developed world could first prompt an inflationary response in emerging economies. Many emerging market central banks are essentially being forced to import easy monetary policies in part because running higher rates would attract excessive capital inflows that would then put upward pressure on the currency, and reduce export competitiveness. So what we have, in many cases, are countries with meaningfully higher structural growth rates than those of the developed world, running real rates in the low single digits — historically, that has tended to be a recipe for inflation in the long run.
At the same time, loose monetary policy and global liquidity tend to be supportive of equity prices. That said, we believe that our portfolio may be positioned against rising inflation by nature of the investment process we
adhere to. We generally own companies with strong franchise value and high barriers to entry. These kinds of companies tend to enjoy pretty strong pricing power so that they can pass along higher costs to customers. We like to own these types of companies in all market environments, and certainly in situations where inflation is starting to pick up.
Babak “Bob” Zenouzi
Senior Vice President, Chief Investment Officer — Real Estate Securities and Income Solutions (RESIS)
The current Federal Reserve policies are forcing investors to: 1) invest in hard assets that will preserve against the eventual inflationary result of current policies (that is, real estate) 2) buy financial assets that provide what the Fed policies are taking away (that is, yield). As a result, today’s loose global monetary policies seem to be a bit of a win-win for the real estate sector, even if the monetary policies that drive it are misguided, in our opinion.
Historically, real estate investment trusts (REITs) have been a strong hedge against inflation, and we believe that this pattern may continue if inflationary pressures begin to increase. In today’s environment, for example, approximately 85% of the debt of U.S. real estate companies is fixed; this figure is higher than was the case during the last cycle (Source: Citigroup). It also bodes well for the real estate sector, since borrowing costs are going to rise along with interest rates at some point down the road. In addition, many commercial tenants are locked into six- and seven-year leases, with rent step-ups over the life of the lease that are tied to inflation. We still have to pick the right companies, but overall, we believe that real estate has the potential to perform quite well in either a rising rate or an inflationary environment.
Brad Frishberg, CFA
Managing Director, Chief Investment Officer of Infrastructure Securities — Macquarie Funds Group
Inflation protection is one of the key aspects that we believe makes global infrastructure so attractive. About half of our portfolio has some form of inflation protection, and often times this protection is direct and formulaic. For example, one of our current holdings, an international toll-road developer with major assets in Australia, has more than 20 years remaining on its concession: it will likely raise tolls automatically every year to reflect the inflation rate.
Another type of listed infrastructure, regulated assets, can also have inflation hedges built into its contracts. Regulated assets include businesses involved in electricity and gas transmission and distribution (that is, the poles and wires, or suburban gas pipelines) that deliver electricity and gas to households, and water companies that provide fresh water and remove waste water.
In determining the price that may be charged to customers, the regulator typically ensures that the regulated company is able to earn a return in excess
of its cost of capital, including permitting the regulated company to raise its tariffs in future years by a level linked to the inflation rate. Thus, regulated entities are able to generate a revenue stream that should grow at least in line with inflation. These kinds of contractual, inflation-linked revenue bases provide infrastructure investments, including many of those within our portfolios, with a very direct inflation hedge.
The views expressed in each outlook represent the Manager’s assessment of the market environment as of January 2013, and should not be
considered a recommendation to buy, hold, or sell any security, and should not be relied on as research or investment advice. Views are subject to
change without notice and may not reflect the Manager’s current views. The views expressed in each outlook are general in nature and do not relate
to a particular mutual fund.
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International investments entail risks not ordinarily associated with US investments including fluctuation in currency values, differences in accounting principles, or economic or political instability in other nations.
Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility and lower trading volume.
“Nondiversified” funds may allocate more of their net assets to investments in single securities than “diversified” funds. Resulting adverse effects may subject these funds to greater risks and volatility.
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