Global slowdowns and central bank tightening are warning institutional investors that focusing on just one particular scenario in a market is a risky strategy says *Dan Kemp.
Morningstar’s investment head has played down fears of a global slowdown due to continuing central bank tightening, warning institutional investors that focusing on just one particular scenario in a volatile market is a risky strategy.
Speaking to Investment Magazine during a week-long visit to Australia, Dan Kemp, the research house’s London-based global chief investment officer, says the biggest challenge most investors face is behavioural because they try to predict the future course of events by relying on a single theme or narrative.
“People see comments or news about an expected recession and the temptation is to position a portfolio for one particular macroeconomic environment,” he says.
“The danger is that if you focus on a narrative, you lose sight of valuation, so you can end up overpaying for a particular theme, whether that’s economic or technological or anything else that people are starting to get excited about.”
“Once a particular scenario is prominent in the minds of investors, it’s likely to be priced in and then you’re unlikely to get any benefits from acquiring those assets.”
Given that the future is genuinely uncertain, any strong portfolio should be built to withstand a whole range of outcomes, whether it is a recession or a growth environment or inflationary conditions, Kemp says.
With central banks flagging more rate rises in coming months to tame persistently high inflation, investors have become increasingly worried further tightening will tip major economies into a prolonged recession.
It has created challenges for professional investors, who have previously relied on traditional index-like exposures or a 60/40 equity-bond portfolios but are struggling to deliver good investment returns in the face of seesawing equities and rising bond yields.
Superannuation funds recorded negative annual returns of -5.5 per cent in 2022, according to data from the Australian Prudential Regulation Authority. The regulator’s analysis has shown that one in five investment options are still generating returns below their benchmarks.
Inflation problem
Kemp, who oversees US$265 billion ($396 billion) in assets through Morningstar’s investment management subsidiary, says professional managers are subject to the same cognitive biases as individual investors, although they have a better understanding and ability to overcome these.
One of those biases has been the willingness of investors to overpay for particular assets such as energy or technology stocks.
Morningstar, which had been enthusiastic about energy companies in 2020 when they were priced for very low energy prices, has been reducing holdings in the sector because values now reflect inflation and high energy prices.
“The valuation of an asset is really important because an asset that is a brilliant defence against sticky inflation may not provide any defence at all if that inflation is already priced in,” he says.
In the current scenario, it is also important to consider the extent to which inflation is eroding or supporting profit margins. While in the past, inflation has tended to erode profit margins as companies have struggled to pass on higher wages and other input costs, things have been different this time around.
“What we’ve seen in this cycle is fascinating. Inflation seems to be supporting some profit margins, particularly in US equities, because they’re able to pass on price increases to customers who are expecting price increases because of that background level of inflation,” he says.
It has resulted in some traditional asset classes used for inflation protection being already priced so high that investors need to be wary about how sustainable margins will be in the future.
Morningstar is seeing fewer opportunities at an industry or sector level and is increasingly preferring to invest on a country basis, such as in Brazil, South Korea, China and Germany.
Kemp also doesn’t see many opportunities in the Australian market, where the benchmark ASX 200 index is up just 3.6 per cent for the year. He attributes the performance to the dominance of materials and financial stocks.
“In the Australian equity market, you are concentrated in a small number of sectors and so you’re more reliant on particular economic outcomes,” he said.
“What that means is you’ve got very different fundamental drivers for returns compared to other markets around the world. And that’s really the argument for diversified exposure.”
ESG-led growth
One area where Morningstar has seen growth in Australia is the increasing adoption of sustainable investing, with investors more keen to express their ESG preferences in portfolios.
This has followed an acceleration in the decarbonisation efforts globally as well as the Albanese government announcing ambitious renewables target and energy transition plans to move away from the heavy reliance on fossil fuels.
“It’s very easy now to exclude controversial investments in your portfolio and to select a portfolio that is designed to have a particular impact. But when somebody has to give up returns in order for their portfolio to reflect their preferences, it tends to get a bit muddled with ESG risk,” Kemp says.
“There’s actually a smaller group of people in the world who are prepared to give up financial returns in order to to adhere to their preferences.”
He says adoption of ESG preferences-based investment is slower in Australia compared to Europe, but it has been far less controversial than in the US.
Where Morningstar has seen strong growth across the world is in the desire by investment managers to understand and price the ESG risk in their portfolios.
The investment research house has built a strong presence in the segment since acquiring the Sustainalytics business in 2020, providing ESG research, ratings, and data across asset classes and investment types.
Kemp says pricing the ESG risk in a business is really important because then that risk can be measured and valued and taken into account when making an investment, just like any other form of financial risk.
“I would see ESG risk as being a key part of financial analysis of all investors around the world and I would see that continuing to grow as it becomes increasingly adopted,” Kemp says.
