Investors need to factor in inflation – Wurts

Eric_PetroffIt may still be the right time to allocate to distressed real estate and debt-related strategies as deleveraging continues around the world and capital remains in short supply.

But a significant factor likely to impact on portfolios in the medium term, according to US asset consultancy Wurts & Associates, is inflation.

In its latest quarterly report, Wurts analysts say US equities are priced to provide the lowest expected, but still attractive high-single-digit, returns over the next 10 years.

Commenting on the report, Eric Petroff, the firm’s director of research, said: “Emerging markets should be the highest equity return class over the next decade due to their high economic growth rates and high dividend yields…We do not see any compelling reason to adopt significant style or capitalization tilts within domestic equities.”

Globally, a more diversified equity allocation should be adopted, to capture valuations in developed markets, higher growth potential in emerging markets, and an overarching hedge against potential dollar depreciation.

“The other important thing for people to understand is the changed relative attractiveness of alternative investment strategies” the risk of a traditional uncorrelated absolute return strategy is higher…(and) is more likely to be a higher volatility market-correlated return stream,” Petroff said.

Although the spreads between credit-based and risk free fixed income assets have narrowed substantially, risk free fixed income remains poised to noticeably underperform credit opportunities.

“We do not see a good chance of being rewarded for taking large amounts of risk in this environment,” Petroff said.

Commodities are priced in US dollars and the US has a significant risk of higher-than-currently expected inflation.

“High inflation pressure gives the global investors the reason to believe that the dollar will get weaker and commodity prices will regain their previous momentum to some extent,” said Petroff.

Despite its allure for retail investors in a climate of rising inflation, a dedicated allocation to gold is not recommended.

“Gold futures markets are in contango, meaning they have a built in loss for investors…trailing period returns are the highest we’ve seen in decades…[and] there is no mechanistic direct link between gold and inflation, but it should be in the portfolio (somewhere),” Petroff said.

Wurts forecasts that a steady ‘U’ recovery that will eventually produce higher-than-expected inflation is most likely to occur, posing a risk to investors such as endowments and foundations but an opportunity for capped cost-of-living-adjusted pension funds.

“This means a more moderate allocation to risk, but most importantly exposure to assets that will benefit from inflation,” said Petroff. “I guess we might find the fourth quarter to be the quarter that things turnaround.”

The report estimates that reasonable returns can be realized in the next five years with a U-shaped recovery and little valuation expansion, with an 8.6 per cent annualized return expected for a portfolio consisting of 60 per cent S&P 500, 20 percent treasures and 20 percent investment grade credit.

Given the economic outlook, the firm says that a W-shaped recovery is too ‘defensive’ but possible. To plan for this outcome, the firm suggests investors to shy away from risky assets that will not see large valuation expansion and focus on those that provide reliable cash flow where dividends and interest payments dominate returns.

“The main risk with this strategy is opportunity cost should we see a U-shaped recovery and associated inflation,” said the report.

The firm says tremendous value can be added through rational and disciplined asset allocation decisions, but not enough to warrant excessive risk taking. Although the government stimulus is staggering, investors need to “sit back, set aside short term concerns, and think about how this much stimulus will play out over time.”

The report also disagrees with the Congressional Budget Office’s forecast for a strong ‘V’ recovery alongside historically low inflation due to high debt and tax burdens.

“Planning for a strong V recovery is just not a realistic course of action,” the report says. “Loading up on market risk and embracing leverage through alternatives will likely result in disappointing risk-adjusted returns,” it stated.