As the much-loved Great British Bake Off nears its conclusion for another year, it occurred to me that contestants are grappling with some of the same vagaries as investors: temperature (will economies overheat or underdeliver), judges (policymakers assessing whether or not they should change the rules of engagement) and peer pressure (how are other people investing and should you be following suit).
Just as every week we see the bakers nervously kneeling in front of their ovens, looking for that perfect rise, the topic front of mind for UK investors at the moment has to be inflation. Much like a cake, it can be hard to predict exactly how fast and high inflation will rise, and to know whether it may simply sink again once the economic temperature stabilises.
The Bank of England’s chief economist, Huw Pill, has warned inflation is likely to hit 5% over the coming months. This marks a change from earlier this year, when central bank rhetoric in the UK, US and Europe indicated policymakers were prepared to overlook what they deemed to be “short-term inflationary spikes”. Now, as we near the end of 2021, expectations are mounting for the Monetary Policy Committee to pull the trigger on interest rates – putting them up for the first time since the pandemic-induced cut.
After a year of lockdowns, spring and summer effectively played the role of an oven heated to 180 degrees Celsius, helping the ingredients of economic normality bind together. As expected this led to an uptick in inflation. However, hopes for a short-term peak followed by a reduction to trend level are now being challenged.
Persistent supply chain disruption and rising oil prices, combined with labour shortages prompting wage inflation, means there are growing fears of the oven (economy) over-heating and the cake (inflation) overspilling its tin. If inflation sticks around for longer and interest rates subsequently begin a reversal from their record lows, then, what impact might be felt on a multi-asset portfolio and how can a manager look to counter it?
The multi-asset recipe
Traditional assumptions consider inflation and rising rates as generally negative for fixed income, neutral for equities (depending on the business model of the company in question) and in some cases positive for alternatives, particularly if revenue streams are linked to inflation.
Happily, a multi-asset manager is much like a professionally trained patisserie chef. 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 2.4 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 while 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 floating rate note (FRN) exposure by 5.9% since the end of last year to 37% as of 28 October. 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 and 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 1.4% of the portfolio. We feel they are highly valued at the moment and have the potential to display more volatility when and if inflation does hit.
We continue to like convertibles, with an 8% allocation in the portfolio, for their absolute return characteristics. With convertibles you are generally lower down in the capital structure (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 convertibles carefully but have been steadily adding to the asset class over the past few years when issuances arrive and the right conditions are met.
Finally, we maintain an allocation to listed infrastructure companies (currently at 5.5%), which have revenue streams that are in many cases linked to or protected from inflation.
There is a chance inflation could present a greater upset than originally thought by policymakers. The comparisons to last year’s readings have (somewhat understandably) been bumpy as economies got moving again from a standing start. This has naturally made investors and consumers nervous, which can prompt a vicious circle of panic-buying and inflation-hedging that then prompts further inflation.
As with baking, it’s tempting to try and over-control your portfolio when aiming for a real showstopper. But, if the correct preparation has been done in advance, too much tinkering can have the opposite effect, particularly if your multi-asset portfolio has an absolute return mandate like our Tenax Absolute Return Strategies Fund.
Our inflation-hedging strategies have been in place in the fund since the end of last year. This means we were not caught unawares and forced to pay more for the benefit of holding such assets. While others prevaricated on the direction and pace of inflation, we put our strategy in place and waited patiently for the situation to unfold. When it comes to absolute return, capital preservation is the core aim, and protecting investor capital from the ravages of inflation (not matter how transient or otherwise) is a key component of such a strategy.
The above article has been prepared for investment professionals. Any other readers should note this content does not constitute advice or a solicitation to buy, sell, or hold any investment. We strongly recommend speaking to an investment adviser before taking any action based on the information contained in this article.
Please also note the value of investments and the income you get from them may fall as well as rise, and there is no certainty that you will get back the amount of your original investment. You should also be aware that past performance may not be a reliable guide to future performance.