Karl Sternberg: “We are in completely uncharted territory”

Despite the Bank of England's monetary policy committee increasing its inflation expectations in recent weeks, it has stuck to the narrative that above-target inflation will be transitory, and so far bond markets appear to agree. However, recent Investors’ Chronicle podcast guest Karl Sternberg – chairman of the investment committee of Christ Church, one of the largest Oxbridge endowments – says that you should be sceptical of anyone who claims a definitive answer to the inflation debate because we are in completely uncharted territory.   

For the past 35 years, the so-called 'great moderation' has, on balance, been a period of decreased macroeconomic volatility, low inflation and positive economic growth. This has led to significant confidence in the ability of central banks to ensure monetary stability. However, Sternberg notes that this is not necessarily cause and effect. “[Central banks] have taken the credit for huge tectonic forces that have been obvious since the 1980s – deregulation, the rise of China, globalisation more generally, technological innovation, de-unionisation and the mass movement of people,” he says. “All these things have been disinflationary, and have nothing to do with central banks.”

While many of these forces remain, wages have been going up across the globe alongside oil, copper and other commodity prices, but central banks have so far stuck to quantitative easing programmes and accepted heightened inflation targets. Reflecting on history, Sternberg notes that in the 1980s and 1990s there was very tight monetary policy (in the form of high interest rates) but quite loose fiscal policy in the US. Moving into the 2000s, fiscal policy became tight but monetary policy was loose to deal with the aftermath of the financial crisis. 

“Now we have loose money and really loose fiscal policy – a combination we have not seen since the early 1970s,” Sternberg says, adding that each is more potent when used with the other. He also points to an interesting paradox: if central banks are more credible than they deserve to be, their credibility creates the very excesses and instability that credibility was thought to confer in anchoring inflation expectations.

While no one knows what the outcome for inflation will be, and remote working may boost competition (particularly from abroad) and have a deflationary effect on wages, Sternberg thinks that it is sensible for investors to prepare for a period of higher inflation and policy instability.

Where to invest

In the long run, in times of inflation, investors have been rewarded for holding equities and other real assets including property. “All the evidence in the past 100-odd years of data is that with an inflation rate lower than 4 per cent equities are fine, property is fine and bonds might struggle unless governments decide to try and fight the bond markets and intervene at the long end to keep rates lower,” Sternberg says.

Sternberg explains that the worst assets for investors in an inflationary environment are fixed-income products as they offer a permanent depletion of capital. However, he adds that no asset is safe with inflation above 4 per cent: “Nowhere is safe is my important message when rates are rising”.

Long-duration assets are likely to perform poorly in an inflationary environment, so you may want to avoid long-dated bonds as they have a higher sensitivity to rises in interest rates. The chart below shows the yield on 10-year US treasuries and UK gilts over the past 30 years. It shows the effect that low interest rates and quantitative easing have had on suppressing yields.

In an inflationary environment, index-linked bonds can offer some protection, but Sternberg thinks that the premium you have to pay for this in the UK is currently too high. He says: “The problem for index-linked government bond investors in the UK is that the matching requirement for pension funds will mean that there’s an artificial market of forced buyers who buy index-linked bonds designed to promise you a minus 4 per cent real return per annum.”

He describes the requirement for defined-benefit pension schemes to invest in government bonds as a “terrible self-inflicted wound on the UK”. Regulations introduced in recent decades, including stringent solvency and minimum funding requirements and the way these schemes are valued, have resulted in schemes buying more index-linked bonds and other government securities and being big sellers of equities. Sternberg says this is one of the reasons why the UK equity market has been such a poor performer – but this is now changing as defined-contribution schemes grow.

Sternberg thinks that US Treasury inflation-protected securities (TIPS) with a low duration (zero to five-year maturity) and hedged to sterling could be a good place to get some security because the real return is likely to be only slightly negative. You can buy these via exchange-traded funds, such as iShares $ TIPS 0-5 UCITS ETF (TI5G), which has 18 holdings and a weighted average maturity of 2.65 years.  

Infrastructure investment trusts can also be a good substitute for owning what would normally be inflation-linked assets, although many are trading on lofty premiums owing to their attractive yields. As we noted in How to pick the right infrastructure trust, the oldest, more established trusts tend to have the lowest risk, such as HICL Infrastructure (HICL) and International Public Partnerships (INPP), which have an inflation sensitivity of 80 per cent and 78 per cent, respectively.   

In equity markets, so-called value stocks are typically thought of as being less sensitive to interest rates than growth stocks, and generally performing better in times of inflation. However, the accelerated structural technological changes within economies have resulted in many highly cash-generative growth stocks, some of which have utility-like elements and recurring revenues, so the growth-value distinction is eroded. Sternberg suggests that investors hold a mixture of growth and more cyclical stocks. 

As for “60 per cent in equities and 40 per cent in bonds” portfolios, Sternberg thinks investors would be better off with a higher equity allocation, diversified with property and infrastructure, and that bonds “shouldn’t really be a significant part of it”. 

Outlook for equities

While Sternberg thinks that regional investing is “for the most part, dead” for large-cap investors as most money is flowing into global funds, the UK looks relatively undervalued. This is partly because regulation has forced insurance companies and some pension funds to divest from equities, and partly because of uncertainties such as Scottish independence and Brexit.  

The recent slew of takeover bids by international private equity firms for UK companies suggests that overseas firms are recognising value in UK companies too. Sternberg thinks that we will continue to see interest from overseas investors as the pound looks relatively cheap, UK assets are well-governed and the UK has relatively relaxed takeover rules, despite recent legislation on strategically important assets. He adds that quantitative easing has made its way into institutions' pockets and “institutions are flush with cash that they need to deploy”.  

The high level of private equity activity is to some extent a reflection of the favourable tax treatment of debt relative to equity and the greater tolerance of debt in private markets, although tolerance of higher debt levels is growing in public markets. Excessive debt makes the economy vulnerable to deflationary shocks and Sternberg thinks that the government should introduce parity of treatment between debt and equity finance. 

Sternberg also says that the UK stock market would benefit substantially from having a less short-term focus, a problem companies can avoid if they are owned by private equity. “I’ve for a long time thought that UK investors should be willing to have bigger stakes in a smaller number of companies – much of the diversification benefits are gained in the first 20 stocks that you buy,” he says. “If you have bigger stakes in a smaller number of companies you end up caring about the companies as an owner and being prepared to take a longer view.” 

Karl Sternberg CV

1992 to 2004: Morgan Grenfell/Deutsche Asset Management, latterly chief investment officer

2006: founded Oxford Investment Partners (bought by Towers Watson in 2013)

Current positions:

Chairman of the investment committee of Christ Church (Oxford University)

Chairman, Monks Investment Trust (MNKS)

Non-executive director: Jupiter Asset Management, Herald Investment (HRI) Trust, Clipstone Logistics REIT (CLR), JP Morgan Elect (JPEI) and Lowland Investment Company (LWI)