With the outlook for inflation and interest rates being critical for returns many investors are wondering how they should position their portfolios if interest rates are expected to remain higher for longer.
While inflation has been falling, it is proving more difficult for central banks to tame and bring down to their target level with the RBA not expecting inflation to return to its 2 per cent to 3 per cent target range until December 2025. Persistently high inflation means that central banks are now expected to keep interest rates at the current high levels for much longer than previously thought.
The stickiness we’ve seen in inflation is being caused by a surge in energy prices and very tight labour markets, which is the narrowing gap between available jobs and people available to fill those jobs. The tragic events unfolding in the Middle East have added to concerns of inflationary pressure as world oil prices have been pushed higher.
We’ve seen increased volatility in equity markets in response to this growing expectation of central banks keeping interest rates higher for longer. Predicting short-term market movements is difficult, but taking a longer-term approach minimises the noise and gives more clarity to forecasts. The outlook for equity markets over a 10-year period remains positive (particularly for Australian equities and international equities ex US) so investors shouldn’t react to current news and geopolitical events by making major changes to their portfolios.
A more sensible approach would be to tweak portfolios with a gradual increase in exposure to asset classes that are likely to give better than expected returns if inflation remains high for some time. Some examples of such asset classes are global infrastructure, high yield debt and inflation linked government bonds.
Global infrastructure assets invest in the physical networks and facilities essential to the functioning of society such as power, transport, waste, water and so on. This asset class has underperformed over the past 12 months but is now attractively priced and expected to deliver strong returns over the next 10 years.
High yield debt comes in many different forms and with different risk and liquidity characteristics. Broadly high yield debt produces returns that are close to those of equities, but with lower risk. They are loans where there is a meaningful chance of default, but the investor is paid higher interest rates to compensate for potential losses. High yield debt assets have a forecast average return of 8% pa over the next 10 years.
Inflation linked government bonds are government bonds that are indexed to inflation, so their principal and interest payments rise and fall with the rate of inflation.
With rising interest rates secure fixed interest assets are now providing more attractive yields so investors may also consider adding to this asset class, in particular longer dated investments targeting a 5% plus yield to their portfolios.
In this higher for longer environment investors should take a measured approach and stick with their long-term equity investments and consider adding exposure to global infrastructure, high yield debt and inflation linked government bonds within their secure fixed interest assets.