A guide to investing in the new normal

It seems pretty clear that inflation is easing and we’re heading into an easing cycle. Some central banks have already kick-started the process, such as New Zealand, the European Central Bank and Canada, while eyes will be on the US Federal Reserve this month.

While Schroders’ Sebastian Mullins agrees inflation will drop in the short term, his view is that we should expect inflation in the longer term to be higher than what we were used to. After all, we’re not seeing the same deflationary pressures as we saw following the GFC.

“We’re not saying we’ll go to 1970s-style inflation, but if 2% was the ceiling of inflation in the US for the past decade, we think it’s going to become a floor,” says Mullins, tipping inflation to sit between 2-4%.

In essence, we should be getting used to the current environment as “more normal” than we’ve seen for some time.

In a recent episode of The Rules of Investing with Livewire's James Marlay, Mullins shared why he believes inflation will remain higher and how he is investing across asset classes for this.

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Why inflation will be higher in the long term

Mullins is clear that he’s not tipping the era of 9% inflation to become the norm, but rather inflation to settle in a pattern higher than what we were used to post the GFC.

He notes that inflation has been falling as a result of structural drivers like AI and productivity, however there are other factors that will maintain a certain level of inflation between 2-4%.

One factor is fiscal stimulus and populous governments that are “spending to get votes”.

“You’ve got de-globalisation and we’re not saying we’re going to stop making things overseas, but the pendulum is swinging back in the other direction,” Mullins say, noting that countries can no longer outsource everything to countries like China and hyper-specialisation, such as Taiwan’s chip-making capability, is reversing to allow security of supply.

Security spend is also inflationary, with Mullins highlighting military defence, cybersecurity, food security and minerals.

Finally the demographics are different compared to post the GFC.

“Historically, ageing demographics means that inflation goes lower, which is probably true for countries like China,” he says, before pointing out that retirees are spending not saving now whereas the younger generation are moving into saving modes.

“That might also be inflationary in the medium term.”

Mullins points out that Australia itself is in more of a stagflationary environment, as inflation has been more sticky.

“Fiscal stimulus is keeping the economy going and probably keeping prices high while the Reserve Bank is trying to put the brakes on,” he says.

He views the rate cut path locally to be more volatile, particularly as the RBA remain more hawkish in their tone as they monitor the progress of inflation.

Is a recession coming?

Mullins uses a model with 20 indicators and notes around half of them are flashing. However “there’s nothing in the imminent recession components of that model to say one is coming in the next six months.”

He anticipates some of the indicators will switch because the US Federal Reserve is likely to start cutting rates soon.

Added to that, the US went into the downturn in a better fiscal position than in the past.

“The US consumer de-levered after the GFC, reducing their amount of debt to GDP. Corporates have levered, but net interest payments (interest expense on debt minus interest received on cash) has plummeted because companies are spinning off cash (high earnings) and earning interest on that cash,” he says.

That is – US consumers and corporates are doing well, so a recession looks unlikely.

Mullins is also seeing signs that global trade is recovering, such as the fact that “Taiwan exports are off the charts and mainly chips,” or the size of new orders in Sweden.

With the US having seen outsized market returns, he anticipates the rest of the world is needing to play catch up in the coming year.

How to invest in the current market

When it comes to asset allocation, many across the world have been concerned about valuations in US equities, but Mullins because they are expensive for a reason.

“They are delivering excellent earnings and they have free cash flow and the Mag Seven are excellent companies delivering, and have monopolistic pricing power,” he says.

He favours US equities over Australian equities, arguing it doesn’t have the same pull power.

“CBA, for example, has a higher price-to-earnings peer ratio than Google,” he says.

He notes that Japan, Europe and China are cheaper but China at this stage is cheap for a reason.

His portfolio is long US equities but they use protection, “you can buy put options for historically cheap levels.”

On the reverse though, Mullins prefers Australian credit over US credit.

“Aussie credit spreads are very wide. Historically speaking, they’re wider than the US which never happens because our credit quality is a lot higher. But you can get very, very attractive yields on Australian credit, say between 6-7% depending on where in the stack you go,” he says.

He is watching for opportunities to add high quality duration to the portfolio as cuts start to be priced in.

“We would wait for some of those cuts to come out of pricing and that might take a month. The market has gone from 5% yields to 3.5%,” he says.

He thinks a better entry point will come in a few months.

The asset class to deliver inflation beating returns over the next five years

Mullins notes you can’t typically go past equities for returns over five years, however, “because we’ve seen risk premia reprice across all assets, I think most assets will actually outperform inflation.”

He also holds a positive view on government bonds as an inflation-beating asset, “if you think about what inflation break-evens are on inflation protected bonds over a five-year point in Australia, if inflation is higher than 2.3% over the next five years, you’re better off being in inflation-linked bonds and sovereign bonds.”