Surviving the investment rigors of inflationary times
The US Federal Reserve is unlikely to pause interest rates increase anytime soon as it appears determined to fight inflation and see the economic engine cool off.
The Fed knows it is treading a thin line, and its determination to fight inflation could tip off the global balances of a complex monetary system and trigger a long-awaited recession. So far, it hasn’t.
On Feb. 19, 2023, the numbers showcased a resilient US economy — rising household income, consumer resilience and layoff data — all boosting investors’ expectations that the Fed’s battle against inflation will likely be longer than they hoped.
The Fed may be correct in continuing to raise interest rates a bit further, perhaps for a more intuitive reason: Inflation by different measures is so high that the current benchmark rates are still negative in “real-life” terms, which induce investors to take on more risks, overpricing assets and creating bubbles with the potential to burst and bring down economies.
So, what does that all mean for Saudi businesses and investors?
The Saudi Arabian Interbank Offered Rate has increased by more than 400 basis points in the past 12 months, meaning borrowing has become significantly more expensive.
What is meant to cool off an over-heating US economy and abate high dollar-based inflation is having implications for Saudi investors and businesses.
Saudi inflation numbers of about 3 percent are not as high as the US or European levels. Hence, the increase in Saudi benchmark rates could have greater penalizing implications on the private sector and non-oil gross domestic product, especially investments and consumption. Fortunately, the current Brent levels counter any negative macro effect on the Kingdom’s economy.
That said, Saudi companies relying on the debt will likely see their net profits drop significantly or turn negative depending on their historical operational efficiency or previous appetite for debt financing.
They could face the prospects of restructuring their debt and operations to survive the next few years, particularly if they are under competitive pressure or their sales drivers do not positively correlate with growth sectors such as tourism and entertainment, energy and infrastructure spending.
The last few months have seen a significant decrease in long-duration fixed-income valuation, which may present potential opportunities for long-term investors looking to secure higher yields, such as the 5 percent Saudi sovereign yields.
However, it’s essential to consider that this opportunity would depend on the stability of interest rates and whether inflation remains abated.
On the other hand, should recessionary signs start showing up, fixed-income assets could quickly turn around as the prospects of lower interest rates increase. Therefore, Saudi institutional investors who are likely in for the long term, such as Awqaf endowments, pension funds or insurance companies, would want to assess such opportunities at this stage.
Investors should consider certain factors while investing in this asset class during such times. For instance, they should focus on dividend-paying stocks of debt-free companies in high-growth sectors with revenue models that allow passing price increases to consumers may be beneficial.
Investments in energy, materials, industrials and healthcare have been consistently positive performers during inflation windows, as they benefit from an ability to pass through costs due to their clients. While they could outperform the market during inflation, they also have the potential to be resilient during recessions. Current volatility warrants caution when investing in companies with a strong dependence on future financing and rosy future economic assumptions, like “growth stocks” that derive value primarily from highly speculative capital gains in the future.
Select private equity investors may be better positioned during periods of uncertainty due to their increased control over the different stages of the investment process, such as asset selection and investment underwriting and the post-acquisition stage.
It’s essential to assess and consider diversifying investment portfolios beyond
traditional assets in times of uncertainty. For example, some investors may choose to include precious metals, such as gold and other metals known to perform well
during times of uncertainty.
While rising commodity and energy prices have contributed significantly to Saudi Arabia’s growth, they have been the primary driver behind the global inflation increase that the Fed and other central banks have tried to fight.
If the tools used to counter inflation trigger possible stagflation, recession or financial crisis at a global scale, it would have a direct impact on the Brent price levels as the world aggregate demand drops.
Saudi investors should consider building such probability should they heavily invest in the oil sector and ensure they are hedged through diversification in less correlated instruments or derivatives. Traditional strategies such as the 60:40 bond-equity ratio or real estate as an inflation hedge have disappointed and have proved impertinent during uncertain and volatile times.
Therefore, Saudi investors and businesses are encouraged to build investment strategies based on market fundamentals, allowing them to benefit from the expected growth while being equipped to face the worse.
• Firass Hathout is head of investment, growth & restructuring strategies at KPMG Professional Services.
• Mohannad El-Rass is director, investment & financing advisory at KPMG Professional Services.