Smart money readies for inflation

Posting a stellar performance this week, the Future Fund also offered a free tutorial in how to prepare for a very different market

in just three months, the Future Fund has dropped its cash from 19 per cent of the portfolio to 13 per cent while lifting shareholdings from 25 per cent to 27 per cent.

Ask most investment professionals about the threat of inflation and they have the same answer: “We think it’s a short-term thing, it’s transitory – it will disappear very soon.”

But if you go higher up the tree and ask someone like Peter Costello, chairman of the $2000bn Future Fund, which just reported a 22 per cent annual gain (streets ahead of returns from most super funds) you get a very different ­answer.

Costello and his CEO at the Future Fund, Raphael Arndt, were answering the usual questions this week about the fund’s view on the markets when the cliche of “transitory inflation” was again raised.

Quick as a flash, Costello brandished that ability to cut through the twaddle that made him an outstanding federal treasurer. “It’s too easy just to say it’s transitory and it will all disappear … inflation is the central issue for financial investors at the moment,” he said.

No sitting on the fence there!

Costello then echoed what a small but vocal minority have been saying for months: investors have to get ready – ignore inflation now and you may pay a high price in the future.

All investors – especially retirees – will take a hit if inflation gains a grip in the months ahead. Nobody wants to see purchasing power eroded or find themselves flat-footed in a market that has reset its priorities.

And even if, as everyday investors, we can’t fully copy the Future Fund, we can take some useful guidelines from how it goes about its business.

The fund is not waiting to see if inflation “readings” near 5 per cent each month in the US extend further. Nor is it trying to see through our own modest reading in the Consumer Price Index: how seriously can we take the CPI anyway if it does not include house prices?

Rather, Arndt is reviewing the fund with the inflation scenario in mind. According to Arndt: “The conditions are there for another sustained increase in inflation and this is very, very damaging for investment returns when you’re starting at a point where real interest rates are negative or zero.”

So what is Arndt and his team doing?

The key move in the past three months has been a willingness to spend down some of its cash reserves and load up in shares. It is also pushing into unlisted markets in private equity and infrastructure. In other words, they are “inflation proofing” the portfolio.

Portfolio managers such as Arndt play their cards close to their chest. They speak in code, but the numbers tell the story: in just three months, the Future Fund has dropped its cash from 19 per cent of the portfolio to 13 per cent while lifting shareholdings from 25 per cent to 27 per cent.

What sort of shares is the fund picking up? As Arndt explains: “Companies that have some protection around their margins – and provide staples – are likely to do better in an inflationary environment than companies that aren’t generating any profits.”

If you have been wondering why the crew behind Afterpay (which announced a seven-fold increase in losses this week to $156m) sold out a few weeks ago, Arndt’s dictum might shed some light on the timing.

On the flip side, the Arndt approach of looking for profitable stocks that have the ability to lift prices should inflation escalate, would explain why stocks such as Sydney Airport can still sell for $7.70 despite the absence of air traffic or shoppers at the facility for months.

For most retail investors, the key lesson from the Future Fund is that you have to stay in the market. And the “price making” shares – Woolworths, Transurban, the big four banks – may well be much more highly rated in the months ahead than they are just now.

Beyond the world of ordinary shares, there has also been some interesting developments in recent weeks that shows that investors of all sorts – not just sovereign funds – are making sure they are inflation-ready.

Beyond ordinary shares, there are two other areas that investors might also consider in light of inflation fears – gold and property.

The argument for gold as an inflation hedge is well established. What’s more, unlike previous ­periods of inflation, investors no longer have to buy the “barbarous relic” and keep it in a vault.

Gold-focused exchange-traded funds are now very popular and more accessible. The price of gold in Australian dollars has risen about 10 per cent in the past six months.

But perhaps the most interesting is property – bricks and mortar – from residential investments to listed property securities.

Earlier this week, Justin Blaess at Quay Global Investors, published some research work he had carried out in an effort to demonstrate for himself and his clients that property can offer inflation protection.

Put simply, Blaess discovered that investors in real estate – both direct and listed – can benefit when inflation rises. When he looked specifically at periods of higher inflation in the US market, he discovered that the returns from listed property companies “generated more than double the real return relative to equities”.

On closer inspection, it turns out the reasoning behind the Blaess research is similar to that applied by Arndt in his search for the best shares at the Future Fund. In both cases there is the ability to be the “price maker” rather than the “price taker”.

Top stocks can pass on higher costs to their customers because the products are staples. Property owners can reset rents regularly to stay ahead of rising labour or ­material costs.