Sebastian Lyon: Making real returns in an inflationary world

We’re now firmly in a world where inflation – at 6.2 per cent for February’s reading – is significantly higher than the Bank of England base rate, which stands at just to 0.75 per cent. The key question for investors and savers now is how to preserve the purchasing power of their money. 

“There is no way with the amount of debt that there is in the world that interest rates will rise to [the current level of inflation] without tipping the world into a very, very deep recession,” says Sebastian Lyon, chief investment officer at Troy Asset Management and manager of Troy's Trojan Fund (GB00BZ6CNS31) and Personal Assets Trust (PNL) – two portfolios with a focus on wealth preservation. But it's not just dwindling real returns on cash that need to be considered.

“I think investors need to be more realistic about the return they will generate because if inflation is higher it means that long-duration assets, such as growth equities, are of lower value in real terms than they were when inflation was low,” Lyon adds. Whereas in the past decade you could have achieved 4 per cent more than the index without taking on excessive risk, the manager says returns in line with the UK retail prices index should now be considered acceptable.

Lyon notes that there are some "clever" people who still believe the current inflation is temporary, a function of Covid-related supply shocks and stimulus, and will ultimately abate in a couple of years’ time. There are others, equally smart, who think we are entering a world where inflation is much more likely to be volatile because supply chains will continue to be interrupted and, importantly, because quantitative easing was previously used to stabilise asset prices whereas in 2020 it was used to support fiscal stimulus. “I don't think we fully know the impact of that, but that's probably bound to be more inflationary than deflationary,” Lyon says.

Lyon says Troy remains “very open-minded” on the outlook for inflation, adding that he can’t be sure that things will go back to normal. “We may be going into a world where there's greater inflation, and the forces on interest rates are probably upwards rather than downwards, and that has implications for asset prices that are different from the past decade,” he says.

Fund positioning

Personal Assets Trust dialed back its equity exposure last year as Lyon thought valuations were “getting towards extremes” and it now has around 35 per cent in shares, which is at the lower end of the trust’s equity exposure range. Having reduced equity exposure meaningfully in the second half of last year, he hasn’t topped up much in 2022 despite a fall in equity markets because he’s concerned the war in Ukraine “may be a bit of a game changer” in terms of extending inflationary pressures, which in turn make stock markets vulnerable.  

While cyclical companies such as energy producers have performed well in recent months, Lyon is sticking to his philosophy of owning businesses that are resilient, not highly cyclical and can offer growth in the long term. He refers to highly cyclical companies as “feast or famine” stocks which you have to buy and sell at the right time. 

Lyon adds: “We've prefer within our equities to own higher-quality businesses that are less cyclical, more consistent in terms of their profitability, and have long-term track records and management teams that are investing for long-term growth. But – importantly – we don't overpay for that.”

He thinks investors in quality growth companies have to be “very discerning” about running winners aggressively and letting multiples increase. Alphabet (US:GOOGL) – Personal Assets Trust's largest equity holding – is trading on just over 20 times earnings at the moment, “which is not by historical standards very expensive and that is going to grow into that rating very comfortably”, Lyon predicts. Other large holdings in the trust include Microsoft (US:MSFT) and Visa (US:V).

The gross profit margin of the equity portion of the portfolio is around 60 per cent, on average. “We like businesses that have higher returns and greater pricing power,” Lyon says. “One of the reasons we don't like to own highly cyclical businesses is that if you've got a margin of a few per cent, small movements in your top line in terms of sales – and let’s face it, in an inflationary environment there could be big movements – are going to affect the bottom line disproportionately.”

Unilever (ULVR) has been one of the more disappointing performers in the trust’s equity portfolio in recent years, but Lyon notes it has been in the trust since 2004 and delivered “good long-term returns and generated good dividend growth of 8 per cent”. He says that Unilever today looks “very cheap” if you compare its valuation with rivals Procter & Gamble (US:PG) and Nestle (CH:NESN), but adds that the company has had management issues and says he’s watching it very closely.

Lyon thinks management issues have “partly come down to communication”, which he thinks can be resolved. But he thinks it’s also partly because emerging markets, which account for 60 per cent of the company’s business, were always going to be slower than developed markets to recover from the pandemic. 

Diversifiers

Eighteen per cent of Personal Assets Trust was in T-bills, or very short-term government debt, at the end of February, which effectively can play the same role as cash. “If markets are weak and we see there is value in equity markets, we can sell those very quickly and move into stocks, fixed income or gold,” he says. This isn’t particularly unusual for the trust – when Covid struck in the first quarter of 2020 the trust had 30 per cent in cash or T-bills – 20 per cent of which was sold and placed in equities after the sell-off in March 2020, with some also reallocated to index-linked treasuries and gold.

“Obviously in a world of inflation at 6.2 per cent you're losing real value holding cash, but cash even in a world of inflation has optionality,” Lyon says. Cash in an inflationary environment isn't necessarily always the wrong thing to hold, he says, as you are only going to lose as much as the inflation rate, and other assets can be more risky.

Personal Assets Trust has 29 per cent invested in US index-linked Treasuries. Lyon used to own UK index-linked government bonds, but says he sold out of them in 2018 and moved into their US equivalent because real yields in the UK were “much, much lower” and indeed negative, whereas in the US you could pick up positive real yields. In the US, real yields are now close to zero, but in the UK real yields of minus 2 or 3 per cent offer less value.  

“One of the things that I’ve been pleased – and surprised – by is that inflation in the UK has tended to be higher than the US, but in the past year UK and US inflation have been nip and tuck, so within the index-linked [space] we’ve captured that inflation in the US index-linked bonds in a way that you would have done in the UK,” he says.

Part of the reason for the surge in US inflation, according to Lyon, was because the US increased its money supply by around 40 per cent in the 18 months following the outbreak of Covid-19 – far more than the UK did – and “we are now beginning to see the implications of that”, as the manager puts it. 

He says the US index-linked bonds are “at the short end” in terms of duration – around five years currently – given the risks of longer-during instruments in a world of rising rates. He also notes that the portfolio takes long-duration risk within its equity portion and he doesn’t want to double up on this. “You’ve got to accept that you might be wrong – you don’t want to structure the portfolio for one particular outcome,” he says. 

Gold, an asset the trust has owned since the advent of the negative real interest rate environment, makes up 11 per cent of the portfolio. Lyon says he holds gold as an insurance policy that pays out when other risk assets are weaker. In terms of the size of the holdings, he thinks “it's important to have enough to make a difference, but not enough that it is the tail that wags the dog.” 'He says that between 8 and 12 per cent feels like the right level, topped up and trimmed as the price fluctuates. 

“Effectively what [gold] is doing is insuring us from that debasing of currency, which is quite clearly ongoing, in terms of what you can see within the inflationary numbers,” he says. The trust has negligible exposure to property and no exposure to infrastructure – which can offer some inflation protection and are held by many multi-asset funds. Lyon puts this preference down to its low liquidity; he prefers having money in cash or T-bills which can be quickly deployed into equities when markets move and valuations become attractive.

Sebastian Lyon CV

2000 to present: Founder and CIO, Troy Asset Management

1995 - 2000: Stanhope Investment Management

1989 - 1995: Singer & Friedlander Investment Management