UK inflation reached 0.7% year-on-year in January, according to data released in April 2021, with concerns mounting for a higher reading in the next couple of months.
In some ways this is laughable. Over a decade since the global financial crisis and we are still in a situation where a 0.7% CPI reading is seen to herald the start of a rampant inflationary period.
Memories are short, or in some cases, experience is lacking – so investors (professional or otherwise) do not seem to recall far higher inflation in years gone by.
We haven’t seen any real inflation in the aftermath of QE but unfortunately the perception of inflation can be as damaging as the genuine article.
This means an element of preparedness in multi-asset portfolios is wise – particularly if those portfolios have an absolute return mandate, as our Tenax Absolute Return Strategies Fund does.
Preparing for inflation that might not rise
Much like a cake, it can be hard to predict exactly how fast and high inflation will rise and to know whether it could simply sink once the economic temperature stabilises.
Central banks in the UK, US and Europe have all indicated accommodative policy will continue and that they are prepared to overlook short-term inflationary spikes while economic activity ramps back up.
After a year of lockdowns, spring and summer could play the role of an oven heated to 180 degrees Celsius, helping the ingredients of economic normality bind together. If this leads to a temporary uptick in inflation, then much like the mound of a perfect Victoria sponge, we expect it to peak and then reduce again to trend level.
Of course, there is a risk of the oven (economy) over-heating and the cake (inflation) overspilling its tin. Likewise, there is a chance the ingredients (policies) don’t bind as expected and the cake (inflation) fails to rise much at all. This state of disinflationary disappointment is something Japan has been struggling with for decades, while other developed nations have been hoping to steer clear of such a fate ever since they first took extraordinary steps to avert financial collapse over a decade ago.
So how does the multi-asset manager prepare to avert the perils of inflation or its equally threatening cousin disinflation?
The multi-asset recipe
Happily, our multi-asset managers are much like professionally trained patisserie chefs. They have access to the full gambit of portfolio ingredients and experience in combatting all sorts of economic conditions to create the best results. All while being ready to respond to the whims of head chefs (central bankers).
In the Tenax Absolute Return Strategies Fund, we are positioned with a duration of 2.6 years in the fixed income portion of our portfolio. This is about as low as you can be in terms of duration and we believe it to be an appropriate measure to take as we wait for any inflationary readings to work through the system bearing in mind their potential to impact the yield curve.
We have also edged up our AAA floating rate note (FRN) exposure by 2.9% since the end of last year to 34% as of 21 April. FRNs do not suffer the same volatility as other fixed income assets, which is why we own them, and they have done exactly what we would expect year-to-date, having remained flat. Most of them pay around 100bps over sovereign bonds and are either impervious to higher interest rates, or indeed want them.
In the past, we have had a higher allocation to linkers but currently they represent only 1.3% of the portfolio. We feel they are highly valued at the moment and have the potential to display more volatility if and when inflation does hit.
A pinch of spice
We continue to like convertibles, with a 5% allocation in the portfolio, for their absolute return characteristics. Essentially, we are buying a bond which pays us to own the structure, something we look for from all our holdings, while the attached option may become attractive one day.
We also have an allocation of 7.5% to hybrids (named as such because they are rated as 50% debt and 50% equity). Hybrids sit lower down the capital structure of a business, coming higher than equity but lower than most other kinds of debt, so you are paid a premium for that subordination. For this reason, we select our hybrids carefully but have added to the asset class over the past few years when the right conditions are met.
Elsewhere, we maintain an allocation to listed infrastructure companies (currently at 5.9%), which have revenue streams that are in many cases linked to or protected from inflation.
Resisting the temptation to meddle
The convertibles, hybrids and infrastructure holdings, together with a 3% allocation to listed property companies, are included within our overall allocation to equity risk. So, although the specific allocation to equities – at a little under 10% – appears low, the exposure to equity-style risk (and opportunity) is rather higher.
There is a chance inflation could upset the market. The comparisons to last year’s readings are understandably going to be bumpy as economies get moving again. However, we believe the benefits of a strong economic recovery to corporate profits outweigh the risks at this point.
As with baking, it’s tempting to try and over-control the situation in your aim for a real showstopper. But if there’s one thing central bankers are (rightly) cautious of, it’s opening the oven door too soon to have a peek – resulting in inflation expectations, and that perfect Victoria sponge, falling flatter than a pancake.