At 11.1%, the UK’s current rate of inflation is over five times The Bank of England’s target to keep it at 2%. This 40-year high is a sober reminder that the UK’s cost of living crisis continues to hammer households and businesses. A high and rising inflation rate environment presents particular difficulties for investors. Ronald Reagan famously described inflation as ‘as violent as a mugger, as frightening as an armed robber and as deadly as a hitman’. The reason why it is destructive is because of both the effects of inflation itself and the response of central banks to combat inflation. So, what strategies are being deployed by fund managers to negate the impact of inflation?
‘We have preferred to allocate to a much broader range of asset classes,’ says Kenneth McMillan, investment director, abrdn, ‘For example, infrastructure where cash flows are long-term in nature, government-backed and have positive inflation linkage. Asset-backed securities benefit from rising interest rates and have structural protection from defaults. Local currency Emerging Market bonds can provide diversification for investors with many of these countries at different points in their hiking cycles. Lastly, opportunities such as music, biopharma and precious metals royalties offer differentiated risk and return drivers over the long-term.’
‘Inflation impacts all asset classes, either directly or as a result of monetary policy enacted by central banks,’ points out Gene Podkaminer, head of multi-asset research strategies, Franklin Templeton Advisers. ‘There is no single approach to protecting portfolios from inflation, so we pursue a number of strategies, including altering the composition of fixed income in our portfolios, adding real assets such as commodities and real estate, and further diversifying our equity exposures.’
Of course, inflation is one of many risks to be managed, alongside influences such as geopolitical and geographical factors, ESG considerations, economic concerns, and industry-specific issues. Because of this asset managers’ inflation strategies need to reflect the terms of the overall mandates given to them by the asset owners, as it is these asset owners that determine the investment mix across asset classes. ‘Often, few assets will be allocated specifically to manage inflation risks alone,’ says Ravi Rastogi, Partner at EY.
‘Inflationary risks aren’t uniform,’ he explains. ‘Some asset classes fare better than others amid high inflation – such as inflation-linked bonds or assets with inflation-linkage in their revenue income. But, some fare worse, such as long-dated fixed-income bonds. Inflation is also reflected differently in different countries as it happens for different reasons, linked to energy or labour for example, and noting that financial components will vary from one market to another.
Getting the edge with a good hedge
Commodities such as gold and energy have traditionally been good hedges as have equities that are linked to them such as gold miners or energy stocks. ‘However, gold is not performing well currently, in dollar terms, and energy investments can be problematic for investors seeking to be more sustainable,’ says McMillan.
‘Equities which are exposed to inflation-sensitive areas, such as natural resources and commodity-driven industries, including energy and mining, have traditionally been reasonable inflation hedges,’ adds Podkaminer.
While some stocks may be a good hedge, there are others that are more adversely affected. As well as bonds, long-duration stocks such as technology (companies whose peak profitability lies in the future) are particularly badly affected, exacerbated by initially high valuation levels.
‘The consumer discretionary sector also tends to perform badly as incomes fall in real terms and uncertainty increases,’ says McMillan. ‘Inflation-linked bonds which might be expected to do well can again be impacted by whether or not they offered value initially and although the coupons are protected they act as a long-dated bond with the value falling when yields rise.’
In terms of whether more funds are being allocated to debt rather than equity, the answer is not straightforward. While long-term returns for equities may now look more compelling, the range of long-term outcomes for returns remains highly dispersed. The path to these returns may also continue to be highly volatile.
As for the future, Podkaminer is cautiously positive. ‘Looking forward, we believe that the risk/return tradeoff between equities and fixed income will be more balanced overall than what we’ve observed in several years, with respectable yields in fixed income helping to provide a viable alternative to equity returns and volatility.’