As inflation rates rise James explains how a multi-asset approach to portfolio management can mitigate risk for investors.
There are many considerations simmering in investment markets and businesses right now – ESG, Diversity & Inclusion and what a return to a ‘new normal’ post-covid might look like, to name but a few. But one immediate - and potentially more pernicious - issue for investors is inflation.
UK inflation doubled to 1.5% in April 2021 month-on-month to its highest reading in almost a year, according to the Office for National Statistics. May’s figure made for even bleaker reading at 2.1%, meaning inflation is indeed creeping up.
There are a number of reasons for this surge, not least the sheer amount of support central banks and governments have implemented to prop up the global economy since the start of the Covid-19 pandemic. This means a lot of additional funding has entered the market, pushing up asset prices as it searches for a home.
The scale of UK household savings amassed during the pandemic is the highest for decades. According to the Office for Budget Responsibility, cash deposits have increased by £180bn between the start of the pandemic and June this year.
Short-term blip or longer-term trend?
While some inflation was expected, economists now seem equally divided on whether or not we are facing a longer-term, structural inflation or merely a short-term blip. The Bank of England (BoE) has made it clear that it always anticipated inflation to overshoot its target this spring and that this is a short-term blip measured from rock-bottom prices this time last year. As soon as these fall out of the figures, inflation will drop away again.
If they’re wrong, longer-term inflationary pressure could well force the BoE to increase interest rates, which have been held down since the 2008 financial crisis. This is not necessarily a good thing for investors.
Investors should be aware of the effects of inflation on a portfolio. While bond and stock markets have stabilised after an interest-rate scare in March, fears of longer-term inflation could see volatility return.
What does this mean for investors?
Inflation is that ‘thief in the night’ that chips away at the purchasing power of cash and savings. If savings attract interest of say, only 0.5% p.a. and inflation remains at its current level of 2.1% p.a., then the saver is achieving a negative real rate of return of – 1.5%, i.e. after taking inflation into account. The compounding effect of this negative return over time can seriously damage your wealth.
Bonds are particularly sensitive to rising interest rates as the value of the fixed income return they offer weakens and this is reflected in the capital value, or price, of the bond. That is why duration is so important to keep an eye on. Duration is a measure of the sensitivity of the price of a bond or other debt instrument to a change in interest rates. The higher the duration, the more a bond's potential to drop in value as interest rates rise.
With equities, it is more nuanced. Companies with ‘pricing power’ can thrive in an inflationary environment and increase their earnings; for others, inflation expectations and weakening earnings growth can put downward pressure on stock prices. This is where good multi-asset managers can thrive.
Being able to move skilfully between asset classes is a much-coveted capability in times of inflation. Multi-asset managers are able to seek out the best opportunities across different asset classes to hedge against inflationary effects on investments.
The multi-asset solution
So how does the multi-asset manager cope with the increasingly disparate expectations for inflation and interest-rates constantly being distorted by central banks?
Good investment managers should, by now, have already built some inflation protection into their portfolios depending on time horizon and investment objective, deploying an optimal mix of assets that have some form of inflation-linking. Things like floating-rate notes, index-linked bonds, infrastructure assets and good quality equities all have an important part to play in helping preserve the ‘real’ value of capital. Now that inflation expectations are coming sharply into focus, these types of security are seeing increased demand and therefore a rise in value.
Good multi-asset managers will place the capital preservation objective at the forefront of what they do. In any environment but particularly an inflationary one, to ignore this fundamental objective while chasing higher returns is to court disaster and risk serious capital erosion.
The contents of this article are for information purposes only and do not constitute advice or a personal recommendation. Investors are advised to seek professional advice before entering into any investment decisions. 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.