A protective playbook for a crisis unlike any other

MLC Asset Management's Jonathan Armitage has navigated a crisis or two during his working life and argues that this time, it is different. 

At the dawn of his career, he confronted his first; the "great bond massacre" of 1994. With yields at 3% and inflation low, the Fed's then-chair decided to push through six consecutive rate increases. By the end of the year, bondholders suffered over US$1 trillion in losses as prices collapsed.

In his mid to late 20s, he faced his second; the Asian Financial Crisis. During this period, he was forced to grapple with the reality of frozen investments and a large-scale credit crunch as panic provoked lenders to withdraw their credit from the region. Since then, the 2000s' dot-com boom and bust, the Global Financial Crisis and, of course, the COVID-crash. 

From these crises, Armitage has learnt to "think about the unthinkable".

"It isn't just about the things that we would like to happen in markets, but actually, it's about the things that could happen. We're all formed by our own experiences, but I think that's helped condition me to expect the unexpected," he said. 

So what should we expect next? Well, Armitage argues that incredibly low-interest rates and the scale of stimulus pumped into the global economy leave "very little room to manoeuver" if we see further economic weakness in two to three years' time. 

This is an entirely different situation to the GFC, the tech crash or even the Asian Financial Crisis, he said, as the challenges that we are currently seeing within the market are government-induced. So what happens when governments start to reel in their aggressive bond-buying? And how does inflation - whether it be transitory or permanent - play into the current, rather volatile, market environment itself? 

Armitage believes, in the first instance, we will see the removal of liquidity within various parts of fixed income markets, with knock-on effects for other capital markets, including equities. 

"Depending on how that tapering is done, over what time period, and how aggressively the Fed moves, it's possible that reintroduces some real volatility back into, not just fixed income markets, but equity markets as well," he said. 

In this interview, Armitage explains what asset classes he and his team believe are attractive in this environment, where he is seeing risk, as well as why he believes inflation could stick around longer than investors would have liked. 

First, some interesting stats from the interview: 

1.  The US Federal Reserve printed more money in the first six weeks of the pandemic than they did during the entire GFC.
2. America will need to build homes for an additional 3 million millennials than it did for the previous decade. Currently, 40,000 homes are being built per year to meet this demand. America needs to be building 175,000 of them.
3. The yield on US 10-Year Treasuries moved from around 1% to nearly 1.7% and back to about 1.4% in the space of the last five months. Imagine if you had seen these moves in equities. 
4. The US Federal Reserve is still buying US$120 billion worth of bonds every four weeks. 

Note: You can watch the interview below or read an editorialised version. This interview was filmed on 23 June 2021.

Why inflation could be more permanent than we would have thought 

While we have increasingly been talking about inflation over the last few months, prior to that the expectations of a reappearance of equity markets' kryptonite were "unbelievably low". 

"It's almost as if inflation had been removed from financial dictionaries," Armitage said. 

An unimaginable amount (over US$5 trillion) of global stimulus later, and the rebound in economic activity is starting to produce some shortages, from the widely publicised shortage in semiconductor chips to shortages in skilled labour. 

"A number of those are likely to be quite temporary, although some of them seem to be taking longer to sort out than we might have originally thought," Armitage explained. 

Other signs of inflation are likely to be more permanent in nature, he said, with skilled labour shortages likely to push up wage costs for certain companies over the long term. 

With many borders still shuttered, the disruption of supply chains is also likely to lead to long term inflation, Armitage said. 

"One of the outcomes of the pandemic is a bit of a movement for supply chains to move from 'just-in-time' - companies running very lean inventories because they could do - to probably a 'just-in-case' type of supply chain management, so you don't just have one supplier but you have two or three," he said. 

"That will push up prices, certainly the cost of manufacturing, and we think companies will try and pass that through to their customers and that will be inflationary as well." 

It may well be that we also see a further rollback of globalisation, he said, with businesses looking to source things locally to lessen their dependence on supplies from China and other countries. 

"This may be exacerbated if there are tariffs put in place, which means that it actually becomes more expensive to source things from different parts of the world than locally," Armitage said. 

"I think it's going to be an important dynamic to look at over the next two to three years. It will take a bit of time to play out and different businesses will be impacted in different ways."

He also pointed to the US housing market as having a major impact on the permanency of inflation. 

"If you look at the housing market in the US, there is a significant shortage of what the Americans call 'starter homes', what here in Australia we call 'new build homes' for young families," Armitage explained. 

"In the next decade, America will need to build 3 million more homes for people in that demographic than the previous decade ... I think that will probably lead to some more permanent pressures in things like building materials, and lumber." 

At the moment, there are about 40,000 homes being built for this "bulging" demographic of young families, he said, with 175,000 needed to meet the demand. 

"The reason why I would bring it to people's attention is it's a reminder that demographics remain really important. That actually, this is driven primarily because there is a bulge in the American population of that age group, and in the next decade those are all people who are going to be looking for accommodation," he said. 

"Those are the things that I think can help drive capital markets over the medium to longer term." 

And yet, the Federal Reserve has been remarkably consistent in its public comments that inflationary pressures will remain temporary. 

"They want to make sure that the US economy is moving at a good clip prior to them normalising monetary policy, that's what really is the primary focus around this," Armitage said. 

So what happens when the Fed stops buying US$120 billion worth of bonds every month? 

The moves in bond markets that we have witnessed over the past few months have been nothing short of dramatic, Armitage explained. 

"If you had seen the same moves in equity markets that we'd seen in bond markets it would be front-page news, it would be on the seven o'clock news every night. Because it's been happening in fixed income markets people have perhaps ignored it," he said. 

In the last five months alone, the yield on the US 10 Year has soared from around 1% to nearly 1.7%, and then back to around 1.4%, Armitage said. 

"Markets are trying to work out how much inflation risk has already been discounted by markets, but also what those risks will be going forward ... Partly because it's very difficult to be precise about how things are going to play out, but also because we're coming off a period of unprecedented economic inactivity because governments shut down economies," he said. 

One of these risks is that the Federal Reserve will start tapering its bond purchases when it believes the US economy is back running at full speed. 

"In the first instance, I think obviously just the sheer impact that the Federal Reserve is having in different parts of fixed income markets as a buyer of last resort, that obviously starts moving back," Armitage explained.  

This will result in the removal of liquidity from those markets, with liquidity then diminished across other capital markets as well, he said, introduces volatility across all investible asset classes. 

In this environment, different parts of equities and fixed income markets look more attractive than others, Armitage said. 

How is Armitage allocating capital at the moment?

Armitage believes that the strong economic rebound that we have seen globally is likely to continue, and expects further momentum in more cyclical parts of the economy to benefit economically sensitive equities. However, he argues that protection against any pullbacks will be key. 

"By any standard, valuations look pretty full, both in equities, parts of the fixed income market, real estate markets - particularly residential markets given the price rises that you've seen - and also the fact that interest rates remain incredibly low, that it is actually very cheap to borrow," he said. 

"It may well be that we're wrong in certain areas, so where we can add some protection into our portfolios, particularly in areas like equities, that we do that." 

MLC protects downside risk in equities by buying derivatives, Armitage said, which will limit any significant drawdown in the case that we see a pullback in equity markets.

Balancing these protection strategies, Armitage and his team keep a keen eye on ways to participate in investment opportunities.

Another area of interest is private markets, and particularly private equity, he said.

"There are a lot of very interesting companies which still remain private in areas like technology and healthcare, which you can't necessarily easily access through public markets and through normal equity indices," Armitage said.

"They're in parts of the market where you're seeing strong structural growth and where those valuations are still playing catch up to a certain extent with public markets." 

Private credit is another interesting area of the market, he said, with investors acting as a lender to companies - typically for those businesses that haven't been able to secure financing from banks or traditional lenders - for relatively short time periods.

"Over the last four or five years in different economic conditions that's actually been a pretty interesting part of the portfolio to add value to investors," Armitage said. 

And while MLC has a wide variety of portfolios, some which have to stick to a traditional 60-40 benchmark of growth and defensive allocations, Armitage believes that traditional labels of growth and defensive have recently been "turned on their head". 

"Some of those fixed income instruments are just not as defensive as we were all taught at school or at university. And so I think some of those traditional labels are probably less useful going forward," he said. 

"I think that some of those traditional mixes of growth and defensive equities may not be the right ones to help investors achieve their financial outcomes in the way that they might've done in the past."

Armitage's one piece of advice for investors

Armitage's one piece of advice for readers is, perhaps unsurprisingly, that they should seek advice. After all, the current inflationary environment, ultra-low (and in some cases negative) returns from fixed income markets, and the lacklustre rates on cash are likely to have thrown up a number of questions in investors' minds. 

"I think that is one of the things that this period has reinforced; that actually having strong and professional financial advice is incredibly important," he said. 

"Each individual is unique in terms of their requirements, their tolerance for risk, but it's also to help navigate through a period which I very much hope will be unprecedented." 

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