A version of this article was published on Hubbis.com on 23 June 2022

The Hubbis virtual discussion forum of April 21 focussed on the rise of inflation and how Asian private clients should re-position their portfolios to cope with the ramifications of a major sea change in the global economic and financial landscapes. With agility, diversification and strategic allocation all needed as the G7 central bankers try to control inflation without turning off the tap of economic growth, Jean-Louis Nakamura, Chief Investment Officer, Asia & CEO for Hong Kong at Swiss private bank Lombard Odier, offered some valuable insights.

Opening his observations, Nakamura noted that Lombard Odier had been in the camp of seeing the arrival of inflation as transitory, due to pandemic-related disruptions and dislocations.

“The inflation spike in 2021 was initially seen by many as a passing story," he said, “triggered by boosted demand for goods that were suddenly facing disrupted supply and transportation chains due to the onset of the Covid-19 crisis."

As the pandemic abated in early 2022, we then saw successive shocks in energy, agricultural and industrial metals' prices due to the war in Ukraine, as well as the possibility of renewed disruptions in global supply chains resulting from further lockdowns in major Chinese cities and ports.

The rocky road to normalisation

“All these elements have combined to postpone any rapid normalisation in inflation data and further increased the risk of some contamination in nominal wages," Nakamura said. “The inflation data numbers, for example headline US CPI, are now pointing both to a reversal in the drivers of the initial inflation spikes (e.g. used cars) but also to a broader-based diffusion of price increases. The risk of a more deeply rooted inflation contamination is probably the key development behind the spectacular swing in the Fed's guidance and the communication from FOMC officials to hammer…excessive inflation before it becomes more permanent."

This, he said, has led to the growing perception among investors that we might be at the start of a renewed structural inflation phase, especially in light of the apparent de-globalisation of the world economy.

A lid on long-term inflation?

“Nevertheless, in the long-term, we believe structural factors – such as demographics or technology – will continue to generate more deflationary, rather than inflationary, forces," Nakamura stated. “And ultimately, consumer inflation should stabilise at rather low levels in major economies. Accordingly, from our viewpoint, investors' long-term inflation expectations, while on the rise over the last few months, still remain well-anchored under 3%."

The short to medium term challenge for financial portfolios consists in building inflation-resiliency for the next few months, without unbalancing allocations excessively towards a risk that might be less acute within a few quarters.

Not the 1970s all over again

“We still don't believe that the conditions of the 1970s are here, even though it is clear that inflation will be more sticky and more pervasive. Looking at the shorter-term, we do realistically see inflation staying at 5.5% to 6% in the US for the rest of 2022, so we have naturally had to implement or propose a lot of nearer-term inflation hedging in the client portfolios."

To achieve that, recent weighting up on commodities, Nakamura said, had provided an effective and efficient buffer against inflation risk.

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Plugging the leaks

“The way we treat commodities in our investment universe, in our asset allocation, in our risk optimisation, means that allocations to commodities have increased quite materially over the last few months," he reported. “Perhaps we shifted in that direction a bit late, but the shift has been effective. And strong discipline and diversification remain very important across the entire portfolio."

Looking ahead to 2023, Nakamura explained the bank's current thinking – that the story might evolve from an inflation scare to a growth scare.

“While it remains important for investors' portfolios to be equipped against short-term cyclical or supply-side induced inflation, with cyclical commodities or mining stocks as main hedges, what will matter for the next few months is to increase the resilience of portfolios against the expected windfall from the central banks' fight against excessive inflation," he observed. “Inflation cannot be tamed rapidly without some suppression in final demand, and that means a rising risk of a global recession."

How do Lombard Odier support clients in in uncertain times? Read more.

The juggling act

Offering more commentary on the potential growth scare, Nakamura said, “Over the last three months, the world has moved to an expectation that the US Federal Reserve would be perhaps up 250 basis points by the end of 2022. This change is huge, already a significant swing, and clearly the coming actions and guidance of the Fed are all likely to be higher and tighter. This will very probably lead to the US economy slowing down and potentially the fear of a recession will replace the fear of inflation. It is less and less a question of 'if' but rather of 'when' and 'how fast'."

He added that while investors had shown a tendency to underestimate the pace at which the Fed could tighten monetary policy, at the other end of the spectrum, US central bankers tend to overestimate the Fed's capacity to increase Fed rates without hurting the economy.

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Watching carefully

“We will need to watch very carefully to see exactly where and when US growth will start to feel the pain, perhaps it will be in the housing sector first, and then the rest of the consumption sector. Accordingly, we are a bit more sceptical about the cyclical consumption sector and consumer discretionary, and we prefer consumer staples, for instance, as slightly more defensive and reciprocal sectors in the composition of equity portfolios."

All this means that investors should remain disciplined and diversified. They should, Nakamura said, slant their allocations towards assets such as gold, which is supported by lower real interest rates. “We favour gold because it could act as a nice asset to having the transition between this period of very high inflation over solid growth, to maybe slightly lower inflation to much lower growth."

Nakamura also advised allocating more towards long-dated government bonds, which would then stand as better hedges than cyclical commodities. Cash, he added, while unfit in a structurally high inflation environment, could also play a role in this transition.

DPM with realistic expectations

Nakamura's final comment was that private clients should also consider discretionary portfolios to help manage this transition from a high growth/high inflation episode to a possible recessionary environment.

“However, as always, investors must understand what they are buying," he said. “Processes playing a 'long-term value' game might suffer higher losses in the short-term, as they would chase after stocks whose valuation might be under persistent stress. In contrast, risk-mitigating strategies, excessively diversified in nominal assets over the last months, may provide better protection in a situation of falling global demand."

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