Business families have demonstrated their resilience during the Covid-19 pandemic, but some principals are concerned the storm clouds of inflation are gathering over their roads to recovery.
After lockdown restrictions eased and consumer spending increased, the UK’s rate of inflation rose by 2.1% in the 12 months to May 2021, up from 1.6% to April, and above the Bank of England’s 2% target. Andrew Bailey, governor of the Bank of England, said in a speech earlier this month the uptick inflation rate was expected to be a “temporary feature” of the UK economy’s recovery from Covid.
The European Central Bank took a temporary view as well last week. However, the US rate of inflation also rose in May, to 5%, up from 4.2% in April and the highest climb since August 2008, according to the US Bureau of Labor Statistics. Inflation has steadily increased since January, when it was 1.4%.
CampdenFB asked the experts at Ruffer LLP and Russell Investments for their verdicts on inflation trends and what families can do to protect their investments in a potentially inflationary world not experienced for decades.
Alexander Chartres (pictured right), investment director at Ruffer, said the prospective return of inflation was the multi-trillion-dollar question of our time. That was because business models and popular portfolio strategies have been built around the idea of low and stable inflation.
“Fundamentally a more inflationary world requires letting go of many assumptions built-up over the past 30 years,” Chartres said.
“Practically this could mean that many real assets should outperform financial assets, and cyclical businesses with low margins and historically limited pricing power may enjoy relative outperformance versus businesses with high margins and predictable revenue and earnings growth.
“Essential will be proper diversification across assets and geographies to avoid the most hostile conditions for wealth preservation.”
What changes should families consider to the “standard” asset allocation model?
Andrew Pease (pictured below), the global head of investment strategy for Russell Investments, said there were two-time horizons to consider for the inflation debate. The first was the next 12-18 months, where there were concerns the post-Covid-19 recovery causes the recent spike in inflation measures to be sustained.
“Our view is that the inflation spike is mostly transitory, a combination of base effects—from when the Consumer Price Index fell during the initial lockdown last year—and temporary supply bottlenecks,” Pease said.
Russell investments expected it was going to take until the middle of 2022 for the US economy to recover lost output from lockdowns and longer in other economies.
Broad-based inflation pressures were unlikely until after then, Pease said.
“It also means that market expectations for US Federal Reserve (Fed) lift-off in 2022 are premature. We expect the Fed to commence tapering in 2022, with the second half of 2023 the likely timing for the first interest rate hike.”
The second, and arguably more important, time horizon was over the second half of the decade, he said. The debate was whether central banks and governments would allow, or be unable to prevent, inflation moving above 3% on a sustained basis, or whether the forces of “secular stagnation”—ageing populations, rising savings rates, low investment—would keep inflation low.
“This debate is less settled, but on balance we expect inflation to settle near the targets for the major central banks over the medium term,” Pease said.
Russell Investments said inflation was more likely to remain close to 2% over the second half of the decade, but the outcome was by no means certain.
Over the next one to two years, the standard asset allocation model, as in a standard 60/40 portfolio, should perform "acceptably well,” Pease said.
“Our cycle, value, and sentiment (CVS) dynamic investment process has a moderately risk-on bias. Global equities remain expensive, with the very expensive US market offsetting better value elsewhere. Sentiment is close to overbought, but not near dangerous levels of euphoria. The strong cycle delivers a preference for equities over bonds for at least the next 12 months, despite expensive valuations.”
Pease said longer-term, the effectiveness of the “standard model” will depend on the inflation regime. The scenario that inflation remained contained implied major changes in asset allocation were not required.
Returns will be low, but investors would be best positioned by maintaining exposure to the equity risk premium, the term premium, and the credit premium over time, he said.
“The high inflation regime, however, will challenge the standard asset allocation model. The transition to high inflation will likely be accompanied by rising longer term interest rates, which will put downward pressure on equity PE multiples. Investors benefit from less duration and less equity risk—equity being a long duration asset—during this phase. The standard real asset inflation hedges will provide a benefit. These include listed infrastructure, REITS, commodities and gold, but not crypto currencies.”
However, Chartres at Ruffer said a more inflationary world required fundamental changes to ‘standard’ portfolios which were—by definition—optimised for the disinflationary world we have lived in for decades.
“At historically low yields, for example, conventional bonds offer very modest prospective returns in nominal terms, let alone adjusted for inflation,” he said.
“As well as eroding the real value of already minimal returns, a more inflationary world is likely to see the equity-bond correlation flip from negative to positive. This would mean that most conventional liquid portfolios’ principal offset—conventional bonds—would become just another liability.
“Families should therefore consider moving any conventional fixed income allocation into alternative assets which offer a genuine portfolio offset and the prospect of real, as in inflation-adjusted, returns.
“More inflation will also challenge the valuations of profitless tech firms which have thrived in the low growth, low inflation world post-2008. This may mean it is prudent to take profits from the market darlings of recent years and reallocate to less expensive equity markets and sectors.”
Are ‘real assets’ the answer to some of the allocation shifts?
Pease said yes, if we were heading into a new inflation regime, but not so much if we were not.
Chartres said yes, but not all ‘real’ assets were equal. Inflation-linked bonds, gold, commodities, real estate and equities were all examples of real assets which could help preserve wealth in a more inflationary world.
But starting points mattered, Chartres said.
“Global prime real estate, for example, trades on very low yields already. And equities in aggregate tend to de-rate once inflation moves above about 4%.
“Inflation-linked bonds look expensive given their negative real yields. But if you believe that real yields can become increasingly negative as financial repression deepens, as in interest rates are forcibly held well below the level of inflation—our central thesis, then they look good value. Gold will also thrive in this environment, as would other commodities.”
After a 40-year bull market in bonds, have we reached the inflection point?
Pease said predicting the end of the bull market in bonds has been a “widow-maker” trade. The recent rally in the US 10-year Treasury to 1.35% demonstrated the pitfalls of confident predictions and aggressive short duration positioning.
“The question about the future direction of bond yields is essentially about estimating the long-run equilibrium interest rate for an economy—the rate that matches supply of savings with the demand for spending on investment,” he said.
“The challenge is that economic theory provides very little guidance on estimating the equilibrium rate.”
Pease said we may be close to an inflection point in the 40-year bull market in bonds, but uncertainty about the equilibrium rate and the longer-term inflation outlook means we should be cautious about expecting a large rise in long-term interest rates.
Chartres said it was impossible to say whether this was, or was not, the inflection point.
“You can say with certainty, however, that the extraordinary performance of the past four decades cannot be repeated given present low yields.
“Bonds are a mathematically bounded asset class: you need yield to compress to make capital gains. If yields are very low, you know that your capital gains potential is limited, on top of minimal income. As we saw in Q1 2020, with the worst US Treasury performance for several decades, investors face not only very low returns, but the potential of equity-like drawdowns, too.
“For conventional bonds, therefore, the symmetry on any reasonable investment time horizon is firmly against you—even if inflation reverts to its previous low and stable regime. And if inflation is back the outlook is even worse.”