Welcome to the February 2022 Manager Panel! Each month, where relevant, InvestNow will ask some of our fund managers some questions about a topic. We’ve asked Mark Donnell (Lighthouse Funds) and Greg Smith (Devon Funds) for their views on what investors should do, if anything, in response to this inflationary period.

Q1: What, if anything, do you think retail investors should do in response to the current higher rate of inflation?

Firstly, stay calm.  Equity markets’ short-term movements are driven by the most hyperactive investors and those short-term movements are almost always over-reactions.

Instead, with inflation and interest rates take your cue from the bond market, particularly the trading in government bonds.  Bond traders don’t get distracted by meme stocks or charismatic billionaires, they just think about inflation expectations all day every day.

Right now the bond market is signalling it (still) thinks this inflation will be transitory.  The rates on 1- and 2-year bonds have risen strongly in the last few months, but the rates on 10-year bonds much less so.  The spread between the 2-year and 10-year government bonds has compressed noticeably.  And the yield on those 10-year bonds is far less than the current rate of inflation.  So the inflation smart money is saying central banks will raise rates in the next one to two years, but largely stamp out inflation across the next eight years.

So keep calm.  The thing about transitional periods is that you do have to pass through them, but stay focused on the long-term.

Secondly, if you do have that long-term focus then now is a good time to invest.  Bad times make for good buying.  “Buy low, sell high” sounds simple, but it means buying at times like this when investing feels emotionally challenging.  But much of successful investing is about keeping a cool head and being patient.  Right now the hyperactive investors’ panic means a lot of good companies are being sold at a discount.  If you have a 3-year or longer horizon then times like this are a good entry point.

Q2: How is Lighthouse Funds responding to the current higher rate of inflation?

At Lighthouse Funds we focus on a 3- to 5-year investment horizon.  We expect equity markets will have regular pullbacks within that timeframe – they happen nearly every year so we expect any 3- to 5-year horizon will encompass several of them.  It seems that 2022’s pullback is connected to interest rate fears.  But so was 2018’s pullback, and even at this current low-point our fund is still 2.7 times higher now than where it was at the low of that 2018 pullback.

So we stick with the plan, and we don’t change our approach in these short-term pullbacks.

Here’s three truths about equity investing:

Truth #1 – To get high returns over the long-run you need to accept there will be times with losses in the short-term.  The short-term losses are the price of admission.  The long-term gains are despite those short-term retreats.

Truth #2 – Most of the time your investment will be lagging its most recent high point.  Our fund has reached new highs on just 12% of the days it’s been running – so 88% of the time it has been below its most recent high.  Yet it’s still averaged 25% pa net returns before tax.

Truth #3 – Your investment will return to new highs in the future, typically quite quickly in fact.  Equity markets have a strong upward bias and they deliver positive long-run returns.  But investors need to be patient to allow that process to unfold.

Q1: What, if anything, do you think retail investors should do in response to the current higher rate of inflation?

Higher rates of inflation are something that investors do need to respond to, or at the very least, consider.  Particularly as we are potentially witnessing an “end of an era” for ultra-low inflation. The scenario of prices continuing to rise over time would eat away at the value of money, and investors, particularly those with an eye on their retirement savings, may be wise to respond accordingly.

Fiscal and monetary responses (successfully) delivered during the pandemic, along with a rebounding economy and supply constraints, mean that the “inflationary genie” is out of the bottle. Inflation is already at multi-decade highs in New Zealand, and indeed in most countries around the world.  This may dissipate to an extent as the world reopens, and supply chain blockages clear, but equally the global economy is likely to continue “re-inflating” post the trauma of Covid-19. Stock markets can thrive (long term bonds less so) amidst rising inflation, but some areas of the economy and corporate sector will do better than others, and investors ought to be mindful of this in terms of sector compositions within their portfolios.

Furthermore, in an effort to counter inflation, central banks are now focussed on tightening measures, and effectively “taking away the punch bowl.” The RBNZ already started on this tightening journey in October last year, and a host of central banks are set to follow suit in 2022 (and beyond). Investors should be aware that the higher longer term interest rates that come hand in hand with the response to an upturn in inflation also have significant implications for companies whose valuations are determined based on earnings and cashflows far into the future.

It is no coincidence that ‘growth’ style investing has performed well during a low interest rate era since the GFC. The market volatility we have already seen this year (with high priced growth companies at its epicentre) is perhaps signalling the start of a wider rotation back towards ‘value’ style investing. ‘Old economy’, value-style, stocks and sectors (that are tied to the economic cycle) could thrive in such an environment and be in for a prolonged period of outperformance over the coming years. Retail investors may also want to consider this in looking at their current investment exposures.

Q2: How is Devon responding to the current higher rate of inflation?

Devon is very aware of the changing environment and the opportunities and risks that exist in an inflationary world. Astute stock and sector selections will be increasingly important over the next few years. Some industries will benefit from inflationary pressures, while others will not. Backing companies with strong pricing power or revenue streams will also be important, and provide an important pathway for earnings growth to be maintained despite a rising cost environment.  We are backing these types of companies across the Devon funds, including the Devon Alpha, Trans-Tasman, Australian and Dividend Yield funds.

Devon is well positioned to take advantage of an ongoing rotation away from “growth to value” as a result of rising inflation. The New Zealand and Australian markets are fertile ground for valuation-conscious investing, given that many listed businesses continue to trade at discounts to their intrinsic value.

Against this backdrop, and as a value-oriented manager, our approach at Devon Funds continues to be to seek out and maintain exposure to high quality companies with excellent investment credentials, including strong track records, robust balance sheets, great management, great economic moats, and strong long-term earnings prospects. Ticking all these boxes and ensuring that we are paying the right price for each business is essential in our view to driving performance outcomes over the next stage of this cycle.

www.devonfunds.co.nz

The above does not constitute investment advice and does not take into account individual circumstances