Magellan chairman and billionaire Hamish Douglass has warned that if central banks are forced to lift interest rates following an outbreak of inflation, then equity markets face a huge reckoning.
In the meantime, investors should brace for more volatility, the fund manger said, especially given the pandemic-fuelled rise of retail investing culminating in the GameStop share trading frenzy.
Bond yields surged in February as investors started to price in the potential for higher interest rates to arrive more quickly than expected as economic growth improved, vaccinations were deployed, and $US1.9 trillion of US fiscal stimulus was added.
The sharp rise in yields invites one of the most important debates in markets, the fund manager said: will inflation prove to be temporary or permanent?
If bond markets are heralding a new inflationary cycle and central banks such as the US Federal Reserve are forced into raising interest rates to counter rising prices, that would be "a disaster" for financial markets, Mr Douglass said.
“Interest rates are close to zero [and] asset prices are very high, reflecting low interest rates. If you raise interest rates to head off a real inflation threat, then hang on to your chairs,” he said.
Still, the chief investment officer of the $100 billion investment manager said that he’s not banking on a persistent uplift in inflation, sharing the Fed’s view that it's unlikely to be lasting.
“If I have to take a view I think this will be transitory, the fiscal stimulus will pass through the economy, and then we are going to be looking back into a factual situation of lower long-term structural economic growth,” he said.
“But I do think that the bond market is going to be very volatile through the rest of this year. People know that bond rates have gone up.”
By the end of the year, higher bond yields and inflation will be adding pressure to markets and “people will be saying, ‘has the Fed got this wrong?’”
At that point, disquiet could develop, “and then we will get volatility and people will be putting bets on around that”. He’s near fully invested, with around 96 per cent of the portfolio in stocks, and isn’t “losing a a lot of sleep” over the inflation story.
However, if inflation does come roaring back, then Mr Douglass believes he is well prepared, with around half of the Magellan Global portfolio in defensive-type companies.
“The portfolio has a very high probability of being resilient if there is a big inflation shock,” he emphasised.
Magellan reported results last month, revealing a 3 per cent rise in net profit to $202.3 million and flat investment performance during 2020 compared to a 5.6 per cent rise in its benchmark, the MSCI global, in Australian dollar terms.
When questioned over performance, the fund manager replied: “We are just in a pincer at the moment. Everyone is risk-on and no one [is] investing in utilities or consumer staples at the moment, and they are half our portfolio.”
And, he said, performance was “masked” by the Australian dollar’s steep climb since March last year. But “we’re not going to protest with market value on a day-to-day basis”.
Another risk brewing for markets is the large-scale entry of retail investors.
It has heightened stability risks, he said, while pointing to the lofty valuation of electric carmaker Tesla and a surge in the value of cryptocurrency bitcoin to $US1 trillion. Both are retail investor favourites.
Mr Douglass cited the stratospheric rise in shares of video game chain GameStop as an example of the crowd-driven momentum that can take hold.
Retail investors appear to have adopted an “almost gambling” mentality to investment “that has no correlation or relation with investment principles”.
He admitted that he is very concerned over the rise of the retail investor with a near-punting attitude. “It really scares me that people are doing this,” he said.
What matters from here is whether they have become large enough to be a systemic risk that could cause a market crash.
“I don’t think that we are there yet,” he said. But, “the larger they get and the more participants and the wider the assets that get captured in this sort of at-scale gambling frenzy, then it does worry me that if it unwinds it could have a compounding effect and a domino effect in markets.”
"I can’t think of a scale when I’ve seen a retail frenzy like this. Maybe you’d have to go back to the South Sea Bubble."