The fiscal and monetary response to the coronavirus crisis has been huge, unprecedented and perhaps unavoidable. Governments have pumped billions into the economy and central banks are keeping monetary policy extremely loose, so some of the worst economic effects of the lockdown may have been averted.
The level of stimulus has reached historic levels. Deutsche Bank notes that the US central bank, the Federal Reserve’s, balance sheet grew from $4.3bn (£3.43bn) to $6.4bn in less than two months of 2020, exceeding the expansion witnessed in the four years following the 2008 financial crisis. The bank has described recent fiscal policy as “just as aggressive”, with one calculation suggesting that front-loaded US stimulus amounted to 9.1 per cent of gross domestic product (GDP) – more than double the amount deployed in 2008.
But such extreme measures have consequences, including a strong chance that the stimulus could give rise to inflation.
“Given the amount of monetary and fiscal stimulus in the system now, and commitment of [fiscal and monetary] policymakers to not withdraw that too quickly, we think there’s a solid prospect of inflation returning in the medium term,” says Charlotte Harington, multi-asset manager at Fidelity.
Nick Watson, a multi-asset manager at Janus Henderson, adds: “You’ve seen quantitative easing come through before, and that has flown into markets and crushed volatility and bond yields. But the difference now is you have the fiscal impetus too. That money could find its way into the real economy. If we go into this big inflationary environment, central banks will be keen to keep interest rates very low. You don’t want to be the first central bank that raises rates and chokes off what could be a fragile recovery.”
This would end a period of more than 30 years in which inflation has tended to ease off, with major consequences. A return to inflation would have a notable impact on investment portfolios, with winners and losers among different asset classes.
But building an inflation-proof portfolio is less straightforward than you might assume. Although it can pay off handsomely, working out the right time to do it can prove to be difficult.
“A lot depends on how strong growth is as we come out of this virus world," says Ms Harington. "So far we’ve seen a growth surprise to the upside and find that growth leads inflation by a year or so. Timing is tricky, but there’s the potential, if you had a vaccine, for growth to thrive and inflation to come sooner. But our view is more that it’s on a one to three-year basis."
The right kinds of bonds
One of this year's most successful diversifying assets could be undone by an uptick in inflation, posing a dilemma for investors keen to offset future volatility. Government bonds, which performed strongly amid a rush into safe-haven assets, look highly vulnerable. Inflation reduces the real value of yields and can generally push investors into riskier assets, both of which hurt bond prices.
So switching from conventional gilts or Treasuries into inflation-linked government bonds, which pay interest adjusted for shifts in prices, could be a savvy move if inflation returns. However, these kinds of bonds incur other risks because they tend to have extremely high levels of duration – sensitivity to interest rate changes – leaving them exposed to any central bank tightening that may follow if inflation gets out of hand.
For example, Royal London Index-Linked (GB00B3MZ2071), one of 13 funds in the Investment Association UK Index-Linked Gilts sector, had a duration of 22.3 years (how long it will take for an investor to be repaid the bond’s price) at the end of May. But Royal London UK Government Bond (GB00B63M5F42), a conventional gilt fund run by the same team, had a duration of 12.9 years.
So if you suspect that interest rates are due to rise after a period of rising prices it may be time to get out of inflation-linked bonds, although many conventional government bonds would also take a hit in these circumstances.
One way to maintain the diversification benefits of fixed income without being hit too hard by a sell-off in government bonds could be to hold a strategic bond fund. These can invest in various types of fixed income, allowing them to shift out of government bonds if they look vulnerable and seek different forms of diversification. This can include investing in areas such as high-yield bonds, which could be among the beneficiaries of a rise in inflation.
But because strategic bond funds have such a broad remit it is important to study how exactly they are positioned and whether they are, for example, avoiding government bonds and keeping their duration low by focusing on areas such as corporate bonds. Fixed-income funds tend to state their duration levels on their factsheets.
Options include MI TwentyFour Dynamic Bond (GB00B57TXN82), which stands out because of its level of diversification and flexibility. The fund tends to be more cautious and lower-yielding than some of its sector peers. It spreads its risk across the fixed-income universe, investing in areas including asset-backed securities, bank bonds, government debt and high-yield bonds.
Going for gold
Gold is a proven portfolio diversifier and some consider that it is a major beneficiary of inflation. Asset manager Unigestion has found that between 1974 and 2017 gold delivered an average return of 10 per cent during periods of inflation. The precious metal also tends to make gains at times of broader volatility.
A gold exchange traded commodity (ETC) such as Invesco Physical Gold ETC (SGLP) gives direct exposure to the gold price. But active gold funds buy gold mining shares, so their returns are likely to be more volatile but much greater when gold prices rise. For example, Ruffer Gold (GB00B8510Q93) has made a return of more than 60 per cent so far this year.
However, the gold price recently hit its highest level since 2011, raising questions about how much further it could go, and the precious metal could struggle if interest rates, or the strength of the US dollar, increase in the wake of an inflationary period. And some analysts, including the IC's economist, Chris Dillow, question whether gold is a reliable inflation-proof investment.
Hugh Gimber, global market strategist at JPMorgan Asset Management, suggests having a broad range of portfolio diversifiers.
Some multi-asset funds focus on areas such as gold, alongside other assets such as inflation-linked bonds. These include LF Ruffer Total Return (GB00B80L7V8), which has focused on wealth preservation by holding assets such as gold, inflation-linked bonds and regular government bonds alongside equities.
Real assets such as infrastructure, meanwhile, tend to perform well during times of inflation because their income tends to be adjusted for price moves. As we pointed out in Alternative investment trusts for the dividend drought, (IC, 17 April 2020), infrastructure investment trusts have been resilient in the face of this year's economic woes, both from an income and total return perspective.
As of 14 July, 34 investment trusts had deviated from their original dividend plans this year or signaled an intention to do this as a result of the pandemic, according to broker Winterflood. But only two of these were infrastructure trusts – GCP Infrastructure Investments (GCP) and HICL Infrastructure (HICL) – which have lowered their dividend targets for their current financial years. And they still had attractive dividend yields, of 6.1 per cent and 4.6 per cent, respectively, as of 13 July.
But infrastructure investment trusts are not trading cheaply. The average generalist infrastructure trust, as categorised by Winterflood, was trading at a 15.6 per cent premium to net asset value (NAV) on 13 July, in contrast to its 12-month average of 13.4 per cent. Renewable energy infrastructure investment trusts also look expensive.
Mr Gimber says that certain absolute return funds, in particular those with a focus on global macroeconomic themes, could be a useful alternative to government bonds if inflation returns.
"Macro funds with a focus on currencies, duration and how sectors perform against each other could be resilient," he says. "This is not so much inflation protection per se, but if you’re concerned about nominal government bonds not working in inflation."
Targeted Absolute Return funds including ASI Global Absolute Return Strategies (GB00B28S0093), Invesco Global Targeted Returns (GB00B8CHD613) and JPMorgan Global Macro Opportunities (GB00B4WKYF80), focus on macro trends and have fared relatively well so far this year.
Funds such as these could withstand volatility at a time when inflation threatens government bonds. Their managers have many tools at their disposal and can invest thematically. For example, ASI Global Absolute Return Strategies said it was using a variety of investment approaches at the end of May, including short-selling US small-cap stocks, going 'long' US inflation and betting that the Japanese yen will appreciate versus the US dollar. If you can identify a fund that is positioned for a rise in inflation, it could be a good option.
However, as we pointed out in the Big Theme of 13 March, absolute return funds have generally been extremely inconsistent as diversifiers, including some of the funds mentioned above. Macro funds can be complicated and their drivers of performance can be difficult to identify, leaving you with little certainty on how they will perform in a given scenario. So approach targeted absolute return funds with caution.
Equity inflation plays
Some types of equities tend to hold up better when inflation emerges, but there are also losers. For example, consumer staples and other so-called 'bond proxies', which can be a stable source of income, tend to look less attractive amid rising prices and could lag other parts of the equity market. This could have an effect on both individual stocks and some of the funds that invest in them.
Equity income funds, for example, look to areas such as consumer staples. These include Evenlode Income (GB00BD0B7D55), whose largest holding at the end of May was Unilever (ULVR), and its top 10 holdings also included Diageo (DGE). Fundsmith Equity (GB00B41YBW71) is another big backer of this sector. But both of these funds, to date, have very strong performance records.
Inflation tends to be beneficial for cyclical stocks such as industrials and oil companies. So some value funds, such as Schroder Recovery (GB00BDD2F190), Jupiter UK Special Situations (GB00B4KL9F89) and Man GLG Undervalued Assets (GB00BFH3NC99) may benefit.
Equity funds with a generalist approach rather than a dedicated value investment style may also be a way to get exposure to cyclical stocks. This is because their managers tend to emphasise certain styles and sectors as their views change. So check their commentaries and factsheets to discern where they are positioned in relation to cyclical names. As we outlined in the Big Theme of 20 November on style drift, certain signs can point you in the right direction.