2021 outlook remains positive for retiree investors, but inflationary risks loom

Slightly more than a year since the pandemic, it highly possible that some people reading this article will have already been vaccinated against COVID-19. It’s a remarkable feat, and marks the transition to a new phase for society and for markets, which after an astonishing rebound in 2020 continue to heat up in the midst of the broader recovery. It’s a complex and rapidly changing scenario, and it contains good news, bad news and some slightly uncomfortable implications for retiree investors.

The good
After the uncertainty of 2020, there is clearly a cyclical economic expansion underway in most developed economies, due to the roll-out of vaccination programs and the vast monetary and fiscal stimulus applied. We believe retirement balances are increasing as part of a broad-based recovery in equity markets, and most diversified funds and strategies would have finished 2020 flat, or in a mildly positive position, compared to the start of that year.

The cycle from the beginning of the pandemic to this point has been much faster than most would have expected. Typically, a serious downturn lasts one to two years, with the early recovery taking another one to two years to develop. The 2020 downturn was one of the most severe on record, yet it only lasted a few months and the early recovery largely occurred through the back half 2020. One year removed from the start of the crisis, we’re already seeing signs of a mid to late-cycle environment.

The bad news
The thing about economic cycles is that they always come to an end, and when this one eventually runs out of steam retirees have a lot to be concerned about. In our opinion, we’re seeing some very early signs that the market might be starting to overheat, and the number one risk at this moment is inflation, and its impacts on bond rates and future cash rates.

Even before that point, in the mid-to-late stages of a cycle the equity market rally is done. This calls for a more nuanced approach to investing, with a focus on sectors and markets that continue to be exposed to the cyclical expansion while more immune to rate hikes and rising bond yields. Three prime examples are energy, materials and financial stocks, and we’ve already seen these sectors outperform over the past few months. We believe that more cyclical regions (such as Europe) and emerging markets can also do well in this environment.

The implications for retirees
Such a turbocharged environment has implications for both capital allocation and asset selection, and in particular brings some implications for those holding bonds as yields increase. The end of the cycle is not necessarily imminent, but in our opinion, it is becoming more and more apparent that inflation and yield spikes are becoming a real risk.

Inflation is a two-edged sword for retirees. In the first instance, the increase in the cost of living generally hurt retirees more than wage earners, who are compensated for rising prices by corresponding increases in their pay packets.

Secondly, we believe an inflationary environment draws into serious question the merits of holding a traditional defensive portfolio that has allocated 50% to bonds and 50% to equities. In past crises, such as 2008-09, when equities have suffered rates have fallen and rising bond prices have tended to take the sting out of market weakness. But if rising inflation pushes up interest rates and bond yields and puts pressure on equities markets, bond prices and equities can become positively correlated, leaving the 50:50 bonds to equity portfolio quite exposed to the end of the market cycle.

Management of this risk requires investors to seek out alternative defensive positioning, especially those insured to provide protection to an extent against inflation and rising bond yields. We believe good examples from past experience have been non-Australian dollar denominated assets and actively managed, diversified funds that utilise options to manage inflation risk and/or offer some form of guarantees around returns.