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As inflation has soared to its highest level for 40 years, financial markets have taken fright, with most bond and equity markets down significantly so far in 2022. In fact, the US is now officially in a bear market, and inflation pressures show few signs of fading – quite the contrary.
But here’s a controversial thought. In one respect, a good dose of inflation may be just what society needs.
Over the past four decades of generally declining inflation, wealth inequality has increased massively worldwide. Since 2008, this process has been turbocharged by the global financial crisis and the covid pandemic as central banks responded by cutting interest rates and printing money to buy financial securities. This has driven up the prices of almost all assets from stocks and bonds to houses, fine wines and art.
So the old, who have accumulated assets over their lifetimes, have got richer, while the young have become relatively poorer. Meanwhile, business owners and shareholders have profited at the expense of workers, whose bargaining power has been eroded by two long-term trends: the weakening of the unions; and the advent of cheap foreign labour (via outsourcing or immigration).
Over time, inflation should help to redress the balance. This will be done partly through higher wages for workers, helped by the move towards more secure supply chains in light of the pandemic and the new cold war with Russia and China.
But what’s good for society at large will feel pretty painful for investors. That’s because the second way it will redress the balance is by eroding the real value of most assets. A whole generation brought up on consistently low inflation and interest rates is now discovering the damage higher inflation can do to portfolios. Can investors do anything to guard against it?
The traditional balanced portfolio relies on a negative correlation between equities and bonds. At any given time, one of the two assets should be rising, helping to protect the portfolio against the downturn. But, as we enter a new regime of greater inflation volatility, investors are discovering that those two core anchors in their old portfolios are moving downwards in tandem.
If – as we believe – this is only the start of a new era of higher and more volatile inflation, investors may want to rethink their approach. We believe the answer is an active portfolio which is genuinely unconstrained and so has the flexibility to pursue capital preservation, rather than tracking – or attempting to beat – a market index. After all, if your manager outperforms the index by 2% but the index is down 25%, you’re still left with a massive loss.
Of course, some assets – such as commodities and inflation-linked bonds – are widely viewed as inflation hedges. So why not cram the portfolio with those?
Unfortunately, it’s not that straightforward. While these assets have a role to play and we have a significant exposure to gold, commodities are also influenced by other factors, such as supply and demand issues, geopolitical risks and currency moves, so they can decline in value even at times of rising inflation. Similarly, inflation-linked bonds are generally driven not by the current rate of inflation but by investors’ expectations for future levels. In addition, they are vulnerable to duration risk – that is, that rising interest rates could drive the bonds’ value down.
We think inflation is likely to be volatile for some time, with sharp falls and rises as the economy adjusts to the post-pandemic realities. In that case, these inflation hedges would tend to lose value in the phases when inflation is declining, and timing such fluctuations is notoriously difficult.
So, to help preserve capital when mainstream assets are falling, our portfolios include less conventional assets – namely derivatives. For example, we have for some years had a sizeable holding of long-dated index linked bonds, based on our view that ultra loose monetary policy would ultimately lead to higher inflation. Throughout this time, we have used interest rate payer swaptions to hedge our duration risk. These have allowed us to retain this core portfolio position while reducing our vulnerability during periods of rising yields.
Similarly, we have used derivatives to hedge against steep declines in equity indexes. We also sometimes take opportunistic positions to benefit from sharp falls in single stocks. Recent examples include areas of overexuberance in technology stocks.
We have a significant allocation to cash. When inflation is high, many managers avoid cash, because inflation erodes its value over time. But we see it as a protection against more severe declines in other assets – the real value falls in bonds and equities can be much more severe and, crucially, as a reserve we can use to take advantage of any opportunities arising from the volatility in equity and bond markets.
Of course, we have to pay for these derivatives, and this can act as a drag on performance, particularly when mainstream assets are rising. But that is a price we are willing to pay for assets with a negative correlation to our equity holdings in the event of a severe market downturn.
The market environment now demands investors be active and nimble, cautious but brave. The balance will be difficult to strike, but essential for the long-term preservation of capital in a changed world order.
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