Stephen Johnston, Director of Omnigence Asset Management
Traditional 60/40 investment portfolios could be at risk if investors don’t increase their allocation to alternative assets
Canada has a stagflation problem. At its most basic, stagflation refers to below trend growth combined with above trend inflation. This tends to cause stagnant or declining real GDP per capita. Canada has a stagflation problem because in simple terms it has a macroeconomic and regulatory climate that inhibits the creation of capital. Without increasing capital formation there can be no sustainable increase in your standard of living.
Going one step further, we must recognize that savings are the sole source of capital in our economy if we want to stand any chance of addressing the problem. Unfortunately, Canadians have low savings rates and disproportionately spend savings or use borrowed money on consumption goods rather than productive goods. Simply put, we consume more than we produce. This has caused Canadian capital formation and labour productivity to fall beyond our economic peers (Canada’s investments in labour productivity are almost half of what the US invests), which in turn is driving our stagnant standard of living.
While we cannot predict with certainty the magnitude or duration of this forecasted stagflation, we must assume that there is a non-zero chance of a significant bout of stagflation and a reversal of the benign economic conditions of the last two decades. Voltaire said it well, “Doubt is not a pleasant condition, but certainty is absurd.” We must bring this attitude to the issue of stagflation’s effects on our portfolios as stagflation creates a difficult set of investment challenges.
How might stagflation affect my investments? A reasonable starting point is to understand that the approaches that worked in the last twenty years during above trend growth and below trend inflation are less likely to work over the next decade(s) if Canada’s economy enters a prolonged period of low growth and above trend inflation. This must not be ignored. In addition, stagflation tends to disproportionately harm the middle class via socioeconomic barbell effects which is another consideration. The socioeconomic barbell is the concept that the middle class share of aggregate income has been declining for decades and may continue to decline in certain macroeconomic climates. In other words, the share of the middle class pie is shrinking.
The behaviour of various assets in the 1970s when Canada experienced the last bout of economic stagflation offers a valuable lesson. The data from this decade are clear – investors with traditional 60/40 investment portfolios were exposed unless they began allocating capital differently.
But are there investments that will generate returns in such a climate? The answer is yes, if we understand that stagflation can actually be a return enhancer for a properly constructed portfolio. For example, stagflation benefits real asset investments as they typically provide improved returns in inflationary markets – they are colloquially known as “hard assets.” Canada has a large and competitively priced universe of such assets in the form commodity and commodity linked investments. These types of assets are also trading at conspicuously low valuations in relation to stocks and bonds. At the same time, Canada’s favourite alternative assets, residential and commercial real estate, may be negatively impacted by stagflation due to rising nominal interest rates and perhaps even more so due to stretched valuations.
Stagflation may also benefit investments that are less linked to the absolute and evenly spread growth of Canadian GDP and more to targeted return drivers. Drivers such as aging demographics, downward adjustments in the size and purchasing power of the middle class or export industries linked to markets with more robust macro conditions.
Some concrete examples of this approach:
Low Cost Casual Dining: Less middle class disposable income or increasing prices at mid-range or upscale restaurants increase tends to drive consumers to opt for affordable dining options. Lower-cost food chains, offering meals at significantly lower prices, become more appealing alternatives. This shift in preference is not necessarily driven by a change in taste but by the economic necessity of getting similar value for less money. The sustained preference for lower-cost dining options tends to drive change in the restaurant industry, with increased growth in the quick-service and low cost, casual dining sectors.
Automotive Maintenance: Less middle class disposable income tends to drive a shift from premium automotive services to basic maintenance and repairs. There is also a tendency for increased demand in aftermarket and second-hand parts as alternatives to new vehicles and parts. New car sales also tend to decline and the average age of vehicles on the road increases. Older vehicles typically require more maintenance and repairs, which drives demand for automotive maintenance services over time.
Farmland: The Canadian agriculture sector is highly export driven, supplying commodities to economies with more robust growth prospects than our domestic market. Viewed through the lens of productivity-adjusted pricing, Canadian farmland also offers a material value proposition in the form of discounted productivity-adjusted land prices. Farmland also tends to provide a superior upside in stagflationary market conditions as it is a unique, non-depleting commodity production hard asset that discounts the production of an infinite series of crops, those crops have highly inelastic demand, low stock to flow and are consumed 100%.
So what is the way forward?
If the Bank of Canada and the federal government attempt to balance all the conflicting pressures they may simply end up with a low growth, high interest rate and a high inflation economy. Unfortunately, this will only delay the inevitable adjustments that are required to fix our macroeconomic and regulatory environment. If this happens investors will need an investment strategy that considers adding or overweighting investments that are markedly different, such as the examples I shared above, from investments that have driven their returns for the last two decades.
About the author
Stephen is a director of Omnigence Asset Management – a multi-strategy alternative asset manager with almost $1 billion in capital across farmland and private equity. Stephen has a BSc. (Genetics, 1987) and a LLB from the University of Alberta (1990) and an MBA (1994) from the London Business School.