In an environment in which inflation in the developed world continues to hit multi-decade highs, it’s little surprise that few managers have ever dealt with such conditions.
Starting his career in 2002, Yoram Lustig, head of multi-asset solutions, Emea, at T Rowe Price, says while he is too young to remember inflation from a managerial point of view, he does have first-hand experience of what it means in the real world.
“When I grew up in Israel in the 1980s, we had inflation of 400%,” he says. “Grocery stores used stickers rather than barcodes back then. As prices rose throughout the day, new stickers would have to be put on old ones, so I know what inflation means.”
Lustig was taught that one of the very reasons you need to invest is because of inflation; that if investors simply did nothing with their money, they would lose 3-4%.
So how is he coping in this inflationary environment, and which assets is he turning to as bonds and equities fall in tandem?
“If we look at US data, in Q1 of this year for the first time since at least 1976 we saw both US equities and bonds fall by more than 10% together,” he says. “The challenge for multi-asset managers is that when inflation becomes the main concern, it can derail both asset classes and you get these positive correlations.”
For Lustig, these joint falls have been triggered by what he describes as a unique set of circumstances, with runaway inflation sparking aggressive central bank tightening, all while growth is moderating amid a world full of rising risks.
“Concern over rising rates and inflation are contributing to a retreat in bonds,” he says. “At the same time, rising rates and slowing growth are weighing on equity markets in a period where valuations are already above average.”
Given what Lustig calls the “unprecedented” confluence of issues currently facing global markets – namely war in Ukraine, inflation and lingering Covid-19 impacts – he says it is difficult to gauge the path forward.
As such, he believes a cautious approach is needed, especially to mitigate more extreme tail events such as a hard landing in the economy.
In search of diversification
“Markets tend to price in the risk of a recession before it occurs and may become more turbulent. Diversification – both globally and across asset classes – could help mitigate this volatility.”
To diversify equity risk, Lustig is using more conservative strategies that can be flexible on duration as substitutes for government bonds. Meanwhile, rather than simply opting for UK gilts, he says investors need to think much more globally when it comes to fixed-income assets.
“If inflation persists and government bond yields continue to trend upwards, bonds may not fulfil their traditional role of diversifying equity risk. Other approaches, such as active conservative strategies or a wider range of ‘safe-haven’ assets, could play a defensive role in portfolios.”
However, while Lustig is putting these tools into practice right now, he is of the view that inflation will soon peak and the correlation between bonds and equities will drop again as a result.
Based on this view, he believes duration should start to act as a good diversifier within his portfolios. Accordingly, during the most recent asset allocation update, the funds’ underweight to government bonds was reduced.
“We are not expecting to make big profits from government bonds on a standalone basis, but instead preparing the portfolios for a slowdown, with the belief that government bonds will start to diversify equity risk again,” he says.
“Traditionally, when you have a flight to quality, investors rush to the US dollar, to treasuries and gilts, and they provide good diversification.”
Lustig explains another way to provide diversification is via safe-haven currencies such as the US dollar and Swiss franc, while exposure to volatility through derivative programmes to mitigate downside risk can also be an effective tool.
“I think we are in the middle of a regime shift,” he says. “I don’t know if it’s appropriate but we refer to it as the ‘PIG’ regime: namely policy, inflation and growth, because these are the three main changes and concerns.
“In terms of policy we are shifting from quantitative easing to quantitative tightening, which has huge, as yet unknown, implications,” he adds. “At the same time, we are moving from near-zero interest rates to rising rates, which will have a massive impact on sentiment.
“We then have inflation at multi-decade highs, while in terms of growth we are potentially moving into a slowdown and possibly a recession.”
One of the major implications of this regime shift, notes Lustig, is that returns from markets are going to be much harder to achieve than the decade-long bull market investors have just experienced. As a result, he says active management is set to become much more important.
‘The rules of the game are changing’
“We’re entering a new regime where it is going to be much more difficult to generate performance by just passively tracking markets,” he says.
“The good old days of just needing a 60/40 portfolio and enjoying the ride upwards are probably behind us now. However, volatility is the friend of the skilled active manager, and this is good for us as we can add more value for our clients.”
Indeed, while Lustig is cautious in his asset allocation, he emphasises the approach is not “overly cautious”. For example, during the past couple of months, the portfolios’ overweight stance in cash has been reduced, and this has been used to trim the underweight to government and inflation-linked bonds.
“Our portfolios are underweight equities but if you compare our beta to that of the benchmark, we are close to neutral, meaning we are not massively pessimistic,” he says.
“However, it’s also not the time to be a hero with huge bets against the benchmark, so we are quite balanced.”
In terms of equity positioning, the emphasis continues to be overweight value and underweight growth, which Lustig says should provide a hedge if inflationary pressures persist longer than expected.
“It’s about blending growth and value as they are complementary styles,” he says. “We will never go 100% growth or 100% value, we simply tilt the portfolios to where we think the wave is heading – and right now we are tilting towards value.”
This means the portfolios are currently underweight the US, mainly through an underweight to US large-cap growth, while being overweight emerging markets, small caps and large-cap value.
“We think financials, which is the largest sector in value, should continue to do well because banks can make more money from lending when interest rates rise,” he says.
“Conversely, interest rate rises are a headwind for growth sectors such as technology, while a strong dollar is making life much harder for US exporters.”
One equity region Lustig notes does have the capacity to outperform is emerging markets, largely because a big weighting of the index is in China.
“In every region you have a unique set of challenges and uncertainties. Covid-19 lockdowns remain a near-term headwind in China. However, the medium-term outlook appears more attractive owing to prospects for more significant policy support, and valuations are attractive.
“There’s a reason we are not overly cautious,” he adds. “We have seen a big sell-off in markets, which means valuations have improved if you are a long-term investor. At the same time, government bonds are starting to look better value, with gilts offering 2.5% and US Treasuries above 3%.
“The key, however, is that we need to survive in the short term and to do this we must use all the tools in our arsenal because the rules of the game are constantly changing.
“This is why I am actually quite excited,” he adds. “When markets are too high and optimistic, I tend to be more pessimistic, but when markets are pessimistic, I feel more optimistic. If you have new money to invest I do think now is a good time to gradually enter the market.”
Yoram Lustig is head of multi-asset solutions, EMEA and Latin America, at T Rowe Price, having joined the company in 2017. Prior to this, he was head of multi-asset investments UK at Axa Investment Managers, of multi-asset funds at Aviva Investors and portfolio construction, EMEA, at Merrill Lynch. Lustig began his career in 1998 as a lawyer.
This article first appeared in the July edition of Portfolio Adviser Magazine