- With central banks taking action, the investment case changes for certain 'inflation-proof' assets
- We look at some problem cases and some surprising routes to an inflation-proof portfolio
As 2021 draws to a close, soundbites about “transitory” inflation are giving way to central bank action. The Bank of England has implemented a surprise interest rate rise at the same time as the Federal Reserve is speeding up a plan to end its bond-buying programme. Not all central banks are following suit, but for UK investors a combination of monetary tightening and elevated inflation readings up the ante. Even if the Omicron variant dampens economic activity and ultimately has the same effect on prices, now is a good time to reassess the tools available to the inflation-wary investor.
Despite the double whammy of tighter monetary policy and higher prices, Some remain relaxed about the prospects for fixed income. Chris Iggo, chief investment officer for core investments at Axa Investment Managers, notes the tightening begins from a “very accommodative base” and adds that the hiking cycle is likely to conclude with interest rates still at relatively low absolute levels.
But the situation could nevertheless be difficult for bonds, as we recently discussed. Particular concerns apply to a subsector that has been an effective inflation play in recent months.
Index-linked bonds, whose interest payments are linked to inflation measures, tend to perform best when inflation expectations rise. Many commentators believe it has been rising expectations, rather than price rises themselves, that have been the real catalyst driving the performance of these assets in 2021.
If interest rate rises continue in the UK and emerge elsewhere that could be extremely painful for inflation-linked bonds, given their high levels of interest rate sensitivity. Jonathan Owen, a portfolio manager at TwentyFour Asset Management, recently argued that this year's gains had been “as good as it gets” for such bonds. Writing a few days before the Bank of England hiked rates, he warned that index-linked bonds were vulnerable not just to higher rates, but also to any dip in inflation expectations on the back of tighter monetary policy.
“If inflation expectations fall as a result of the Bank of England tightening, the subsequent rise in real yields is a double whammy that only impacts linkers,” he said.
Equities: specialist and generalist
Certain shares offer their own type of protection from higher prices. When it comes to sectors, banks are an obvious beneficiary of rising rates. Ryan Hughes, head of investment research at AJ Bell (AJB), points to the ETF space as a straightforward option, for example, iShares S&P 500 Financials Sector UCITS ETF (UIFS) or SPDR MSCI World Financials UCITS ETF (WFIN). However, as we recently noted, potential index changes may leave more payment processing companies such as Paypal (US:PYPL) in the financials category, diluting the exposure of such funds to banks. More concentrated sector exposures are available via investment trusts such as Polar Capital Global Financials (PCFT).
Broader offerings should not be written off. From Fidelity Special Values (FSV) to Schroder Recovery (GB00BDD2F190), value funds capture the relevant sector exposures. UK equity income funds often do the same, while Falco Financial Planning chartered financial planner Matthew Bird highlights a “vanilla UK tracker” such as Vanguard FTSE UK All Share Index (GB00B3X7QG63) as a defensive play. He notes that higher commodity prices would bolster oil and mining shares, while insurance names such as Legal & General (LGEN) look “relatively good value”, and stocks suffering from environmental, social and governance-related outflows such as British American Tobacco (BATS) look resilient enough. The tracker would capture all of these at a low cost.
While certain analysts view the value investing style as a good inflation hedge, a focus on pricing power has led some specialists to quality growth stalwarts. Bird notes that many holdings in the beleaguered Lindsell Train Global Equity Fund (IE00BJSPMJ28) “have been struggling with Covid-related issues but ultimately have strong pricing power and should hold up relatively well in the face of inflationary pressures”. He also rates Fundsmith Equity (GB00B41YBW71) for the strong pricing power of its holdings.
Real assets are still seen as an effective way to defend against inflation, given that contracts and valuations can adjust for rising prices. The options, however, are numerous, investors having to choose between an array of asset classes as well as confronting other decisions such as whether to back a physical asset or a related equity.
When it comes to physical infrastructure, funds such as HICL Infrastructure (HICL) boast a good correlation between their returns and inflation, while renewable energy infrastructure trusts tend to either offer dividends with an inflation link or target a rising payout. But there is a perennial issue here in terms of valuation, not least the chunky share price premiums such trusts tend to command.
There are some ways around this. Alex Brandreth, chief investment officer at Luna Investment Management, instead focuses on shares in the sector via M&G Global Listed Infrastructure Fund (GB00BF00R928).
The premiums to net asset value (NAV) on which most infrastructure trusts currently trade put them in contrast with some other perceived inflation plays: shares in commodities trusts have recently traded at cheap levels relative to their history. Shares in BlackRock World Mining Trust (BRWM) traded at a discount of 4.2 per cent to net asset value on 13 December, compared with an average premium of 0.5 per cent over the preceding 12 months. The trust had struggled in terms of both NAV and share price performance over six months.
Commodity funds have had a mixed year and one metal in particular has struggled in 2021. The gold price is a fair way off its high of August 2020, and some question its credentials in an inflationary environment. While it has fared well in several historic inflationary scenarios, the metal’s performance can be poor if the US dollar strengthens or if bond yields rise. Both have occurred this year, and a combination of tightening monetary and inflationary pressures could again push bond yields and the dollar higher.
Property has its own appeal as an inflation play. Brandreth favours TR Property Investment Trust (TRY) for its well-diversified portfolio of real estate assets. This is a very Europe-centric portfolio, with a focus on shares in property companies rather than physical assets.
Physical property can come without equity risk, but certain subsectors have fared very differently from one another in the pandemic. If logistics plays such as Tritax Big Box REIT (BBOX) trade on high share price premiums to NAV after a good run, office and retail-oriented names such as BMO Commercial Property Trust (BCPT) have rallied fiercely this year but now face yet another hase of uncertainty if further Covid-related restrictions arise. That perhaps explains why they trade on double-digit discounts.
Investors who do not wish to finetune their exposures could simply opt for a dedicated real assets fund. Names such as FP Russell Investments Real Assets (GB00B4KQS127) and Liontrust MA Diversified Real Assets (GB00BRKD9W23) invest across different parts of the property and infrastructure space, as well as using other assets such as commodities. A recently launched offering, ' VT Elston Liquid Real Assets Index (GB00BLB58C88), combines "higher risk/return real assets like commodities and natural resources with lower risk/return rate-sensitive assets like floating rate notes", with the aim of hedging against inflation while displaying volatility similar to that of a UK gilt.
Finally, it should be remembered that capital preservation trusts such as Ruffer Investment Company (RICA) and Personal Assets Trust (PNL) hold a combination of gold, index-linked bonds and equities as part of an inflation-oriented mindset.