MEDIA RELEASE: Markets appear to have trust in central banks’ ability to ‘get the job done’ but there are risks to this view, according to Damien Hennessy, head of asset allocation with Zenith Investment Partners.

“Market-implied inflation expectations remain well-anchored and have actually declined this year, indicating the market is confident the central banks will act and be successful in their inflation fight. Markets also believe the central banks are willing to risk recession. If the central banks ‘pivot’ too soon, markets may begin to lose that confidence,” he said.

In the current environment, he questions how achievable the current ‘CPI plus’ and ‘Cash plus’ investment portfolio objectives are from a medium to longer-term perspective.

“Over the past year, the global inflation spike has weighed on market sentiment, contributing to a broad-based sell-off across many asset classes, with only a small number generating positive returns. In such an indiscriminate market, there's been limited scope for the funds in the real return universe to deliver positive returns.

“The market declines have been so widespread that even those markets perceived to be safe havens in rising inflation scenarios, such as gold and inflation-linked bonds, have struggled, with the latter impacted by the jump in real bond yields. For example, Australian inflation-linked bonds have lost more than 13 per cent this year, despite their inflation protection qualities. Real bond yields are the bedrock for all asset class valuations, hence the focus on some unlisted assets that have yet to show meaningful adjustments,”

Hennessy said.

Andrew Yap, head of multi-asset and Australian fixed income, added that as interest rates have increased, this has seen the risk-free rate go higher which has had a roll-on impact for capital market assumptions and asset allocation more broadly.

“With Australia experiencing its highest inflation levels since the early 1990s, advisers face a common problem – how to maintain the purchasing power of client portfolios and deliver a level of return consistent with investment objectives.

“Real return funds in particular have had a challenging time of late – impacted by the challenge of managing a fund to a set of ‘CPI plus’ objectives when inflation is running well above trend,” Yap said.

The real return category is a group of strategies that target ‘CPI plus’ outcomes and therefore seek to deliver long-term returns that outpace inflation and deliver consistent capital growth. Yap said targeting real outcomes is a client-friendly concept, however the recent environment has highlighted the challenge of building truly ‘inflation-proof’ portfolios.

“The breadth of asset classes with direct linkage to rising inflation is limited to a few markets, such as inflation-linked bonds, commodities and some equities sectors such as energy, precious metals and consumer staples. But some of these are now being impacted by the demand-destruction resulting from the increase in interest rates designed to alleviate inflation.

“Therefore, building a portfolio that could outperform in a rising inflation environment is likely to be challenging, particularly where managers seek to retain portfolio diversification to enhance the capital preservation qualities of their portfolios.

“The recent inflation spike has highlighted that managers in the real return sector rely on the indirect inflation-hedging properties of traditional asset classes to deliver real long-term returns, as opposed to building portfolios with direct inflation linkage.

“While this isn’t surprising, it reinforces the importance of investing over the longer term, the role of real return managers in managing portfolio exposures in terms of allocating capital across different asset classes, and the inclusion of a broad set of strategies to generate attractive real returns,” Yap said.