35 years on from the big bang
On Monday 27 October 1986, the London stock market was deregulated. In a matter of hours, a once...
Inflation is the buzzword in markets at the moment. Prices have risen 5% year-on-year in the US and 2% here in the UK as economies have reopened. The question on everyone’s lips is, after years of very low inflation and interest rates will this be a temporary phenomenon, or will we need to adjust to a new more inflationary environment?
Ruffer’s Duncan MacInnes believes a once in a generation transition into a world of higher inflation is underway. “Inflation is a psychological phenomenon and the expectation of rising prices leads to rising prices. Companies cannot get staff and wages are being forced up. McDonalds is even paying candidates just to show up for interviews. Shortages are a key sign of inflation and, all the while, policymakers are pouring further fuel on the fire.
“When we look at commodities and re-opening stocks, a lot of inflation is now priced in: this is front-page news. Just as today’s inflation numbers benefit from an easy comparison versus lockdown last year, next year’s inflation will require sustained economic momentum to stay up, and with companies scrambling to increase supply, the spike could well be followed by a dip and the transitory crew might have their moment in the sun.
“But what is clear is any relapse in economic growth will be quickly met with more stimulus and more inflationary policies, so we have conviction this current inflationary spurt is the starting gun. We don’t expect inflation to go up in a straight line, but the direction is clear. A once in a generation transition into a world of higher inflation is underway.”
With higher inflation usually comes higher interest rates and the US central bank, the Federal Reserve, is keeping a close eye on things. Tiffany Wilding, US economist at PIMCO, says that it could start easing its bond purchase programme as early as this September, while interest rate rises are now expected in 2023. But as Stephen Snowden, manager of Artemis Corporate Bond fund pointed out, this would take rates only to 0.75% in a year and half’s time – nowhere near the numbers we experienced just over a decade ago.
Chris Iggo, CIO Core Investments, AXA Investment Managers, added: “Is this a ‘wow’ moment for markets? Probably, to be fair. “But there is no need to panic. The timeline is still for at least another year of unchanged rates, giving the Fed time to go some way to reduce its quantitative easing programme first. Luckily, balance sheets are in good shape (except maybe for governments) and investors know that, should the ship start to lurch, central banks know what to do.”
One way for bond investors to tackle inflation is by targeting products offering a higher yield. This is particularly relevant in the bond space, because the income paid by bonds is fixed at the time they are issued and high or rising inflation can pose a problem as it erodes the real return that investors receive.
You can react to this in two ways: firstly, invest in a fund which only invests in bonds close to maturity or find a bond fund that pays a high enough yield to provide a cushion. A high yield bond fund is a logical place to start for the latter with the likes of the Man GLG High Yield Opportunities and Baillie Gifford High Yield Bond funds paying yields of 5.65%* and 4.2%* respectively.
And of course, strategic bond fund managers can make these changes for you. For example, M&G Optimal Income manager Richard Woolnough said: “We believe higher growth and eventually higher inflation will put further pressure on government bonds, particularly at the long end of the curve. As a result, we maintain an underweight duration positioning in the portfolio of 2.7 years. While high yield continues to be an underweight for the fund (13-14% exposure versus a neutral weight of 33.3%), we continue to look for what we think are attractive opportunities.
“Within equities, overall exposure is near 5% and has been rising steadily of late. We have topped up on existing holdings, mainly within energy companies which we believe are providing some attractive valuations. Currently our equity exposure is mainly invested in European and UK companies, with a tilt towards cyclical sectors. We have also trimmed some emerging market exposure because we think increasing inflation – driven by rising commodity prices – could fuel political and social tensions for some countries in the coming months.”
Rhys Davies, co-manager of Invesco Monthly Income Plus, added. “The fact there is the debate on both sides tells you that it is not clear cut,” he said. “Whether transitory or more embedded, there are certainly some inflationary risks. So, the portfolio reflects this with lower duration and selective high yield names.”
The rationale for yield carries across to equities. The City of London and Murray International investment trusts currently yield 4.89%* and 4.6%*, for example. Alternatively, you could look funds investing in companies with pricing power such as Waverton European Capital Growth and GAM UK Equity Income.
Inflation-linked investments are another option. M&G Global Macro Bond manager, Jim Leaviss, currently holds around a quarter of the fund in US Treasury Inflation Protected Securities (TIPS) and other inflation-linked bonds, for example, “as we believe these assets continue to offer relatively inexpensive insurance against the risk of higher inflation,” he said.
Real assets like infrastructure and gold also tend to do better in inflationary periods. First Sentier Global Listed Infrastructure is therefore an option as the managers prefer to invest in real infrastructure assets with barriers to entry and pricing power. Gold funds worth considering are Jupiter Gold & Silver and Ninety One Global Gold.
*Source: fund factsheets, 31 May 2021