How private markets could help navigate rising inflation

Following the financial crisis of 2007-08, the economy settled into a low-inflation, low-growth environment. But recently, monetary and fiscal stimulus as part of governments’ response to the covid-19 pandemic has coincided with economies surging back to life. The release of pent-up savings has met with supply-side issues and a labour shortage, putting inflation firmly back onto the agenda. But will this environment last – and how can investors navigate it?

The market consensus is that this surge is transitory, and there is a fairly low risk of lasting inflation. In this view, the underlying causes of the latest inflation rebound should subside as the world’s economies “reboot”, people return to work and supply chain issues are resolved. But a contrarian view is that the risk of medium-term inflation is underestimated by markets. Structural forces such as shifts in monetary policy, a changing labour force and ongoing deglobalisation could mean inflation surprises on the high side for longer.

Regardless of which view prevails, strategies across the private-markets universe may be equipped to deal with any fluctuations, and a general reflationary trend could provide opportunities. We have considered the implications for our full set of strategies under the private markets umbrella and focus here on two strategies in particular.

Private equity: underlying companies will be key

In our view, inflation within the projected 2-3 percent range (which is still low in a historic context) should have little impact on private equity strategies. However, if increased inflation sparks a wider recessionary trend, this could impact the price of transactions as underwriting becomes more challenging with an accompanying risk of reduced financing for deals. Further, if portfolio companies end up being held for longer as managers delay exits, this could hamper fund managers’ ability to raise new funds. Both trends could result in a slower pace of private equity deployment.

Within PE, sectors like industrials and manufacturing could be hurt by higher inflation if they suffer from higher input prices. Meanwhile sectors like tech and healthcare could be better positioned. Software companies, for instance, may be able to increase prices more easily. Similarly, sectors like education and emerging market healthcare should benefit from strong secular tailwinds.

Whatever the sector, the business model of each underlying firm is key, and the ultimate hedge is to focus on well-run organisations whose managers have a demonstrable track record of successfully navigating previous periods of inflation and recession.

Trade finance: short duration will help

There is already a structural shortage of trade finance globally and a faster-growing economy will make the situation worse, while potentially improving the returns available for investors. Since trade finance instruments typically have very short durations – around 90-180 days – the impact of rising rates would likely be minimal. Moreover, as liabilities run off, new deals can be financed at higher rates. This means there should be only a short delay between rates increasing and investors being able to secure higher offered returns.

Look to private markets for yield and return potential

The long-term, buy-and-hold nature of many private-markets investments, and their ability to absorb or pass on increases in costs mean that, to an extent, the strategies can provide protection against inflation – both from a mark-to-market and fundamental perspective.

But private markets strategies can offer more than that. They may hold opportunities for investors to find yield and access returns, whether through identifying the sectors and companies that are positioned to flourish during an inflationary environment, or through a structure that delivers a close correlation with inflation.

For many, a return to inflation will not be feared. In the context of private-markets strategies, it could even be welcomed.

Emmanuel Deblanc is head of private markets at Allianz Global Investors.