By: Anet Ahern, CEO at PSG Asset Management

You have just lived through an exceptional part of history. No, I am not talking about the Covid-19 pandemic, although it does play an important role in what we think about as the Great Unwind at PSG Asset Management. Rather, I am talking about the extraordinary period of low inflation we have seen over the past few decades. An article by Brookings put this in perspective when they argued that structural factors like globalisation, demographic changes, technological advances better policy frameworks meant that “for nearly half a century, global inflation rates were headed one way: down.”

Global inflation 1900 to 2022

Source:  Brookings

Half a century is a long time. In fact, many investment professionals have only known an investment environment where global inflation rates have been on a long-term downward trend. And while current high inflation rates may moderate as inflation recedes from shock-induced highs (the pandemic, supply shocks and war), it should be noted that future inflation rates may well stabilise at higher levels than those we have seen since the Global Financial Crisis (GFC).

As the article by Brookings continues to point out, previous periods of low and stable inflation (in the 1900s and 1971) were followed by periods of high inflation. They argue that “low inflation is by no means guaranteed”. Our own view is that years of underinvestment in commodities and the need to invest in the green economy already created a structural underpin to higher long-term inflation rates, even before the Covid-19 pandemic highlighted the fragility of global supply chains and the need to onshore (or friendshore) suppliers.

Why does any of this matter?

For many, a large part of their lived experience has been framed by the low inflation world. More recently, this experience has been exemplified by the ultra-low inflation and interest rates that followed on the GFC. If ever there was a time when inflation seemed irrelevant, this was it. And markets did what they do best: they sought out those assets that were sure to be rewarded in a “no inflation” world. Growth and long duration assets thrived, while value and real-world assets saw a bitter and elongated cycle of underperformance. For many years, the low inflation party rocked on.

Outside our own sample frame, lives a whole range of historical experiences that look very different to what we have taken for granted as being “normal”. Now that inflation has made a comeback, our investment frame also has to shift, so to speak. Strategies that proved successful in the low inflation world, are often not as suited to the environment we see ahead.

The need to recalibrate our decision making becomes especially acute, however, when the period we typically use as our historical frame of reference provides a poor representation of the period we are actually in. Recently, PSG Asset Management’s Head of Research, Kevin Cousins, pointed out that: “The use of quantitative measures derived from historical price volatility as a proxy for risk is nearly universal in modern finance. These models typically have look-back periods of 8 to 10 years, in essence calibrating risk on the long period of secular stagnation post the Global Financial Crisis (GFC).

The huge exposure to expensive long duration assets is often justified based on these models. We believe that true risk for investors comes from a permanent loss of capital and, on the other end of the spectrum, the inability to deliver target returns over the long term.” – Kevin Cousins, Angles & Perspectives, Third Quarter 2022.

Letting go of the past is not easy

The adjustment to a new frame, is however not an easy one to make. Many investors are still wondering if now is the time to buy into the winners of the past, as exemplified by the mega-cap technology darlings of the past. As one example: if the price of Meta, had retreated by around 75%, then surely it must follow that it would be offering value (the argument goes). But few stop to realise that the low inflation dynamic kept the cost of capital low, favoured growth stocks, and generally created an environment that really suited these kinds of counters. This was reflected in spectacular valuations and a high concentration of certain counters in indices – investors simply wanted to invest in these perceived winners at any cost. And for many, owning these shares still hold a lot of appeal based on their perceived status as performance stocks. However, herein lies the trap. Focusing on whether the prices of these assets have fallen enough, is the wrong question to be asking.

The question investors should be asking themselves is not should I buy tech stocks now, but rather: what should I buy that is suited to the new environment and that is likely to become the performance stocks of the future. The answer is wildly different from what many would expect. In a higher inflation environment, it is often energy, value and banking stocks that are well-positioned to outperform. And as the performance of these assets were typically hurt by the same factors that benefited growth and mega-cap tech stocks, their representation in indices have typically shrunk. It is crazy to think that, even after the run-up in energy prices, energy stocks still represent only 5.1% of the S&P 500 Index, even as we remain so reliant on energy as the driving force of the global economy (as at January 2023).

Moreover, our analysis shows that most of the widely held global funds that are available to SA investors, are not positioned for the new reality either. This means that unless investors make a concerted effort to shift their investment frame, they will remain trapped into investing into what had worked in the past – and their long-term investments outcomes are likely to suffer as a result.

Sources: PSG Asset Management and Morningstar, fund data as at 30 September 2022

We may not realise it, but the past few decades have not been “normal,” but rather exceptional. Investors need to reframe their thinking to successfully navigate the environment we believe lies ahead. To do so, they need to have a truly differentiated perspective, based on thorough research and a proven investment process that has been shown to navigate a variety of investment environments successfully. Simply defaulting to the strategies that worked in the past is unlikely to yield the required results when in fact your frame has shifted, and you find yourself in a completely different investment environment.

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