So what can be done to position charity portfolios? Last year showed how damaging a steep rise in inflation can be for investors, as almost all assets fell in tandem. More recently, many have bounced back. But markets now seem to be pricing in an unrealistically benign outcome for 2023, with growth holding up well and US interest rates starting to come back down. But rates are only likely to fall if inflation falls sharply and the economy slows dramatically, which would be bad for equities and other risky assets. If rates stay high longer than the market is expecting, that could lead to further market falls – or even a more damaging liquidity crisis.
The outlook seems especially challenging for illiquid assets such as property, private equity and private debt, where prices don’t yet reflect the current economic and financial reality. In the case of private assets, the picture is further clouded by debt which has accumulated since the global financial crisis. Last year’s leveraged LDI crisis impacting pension schemes shows just how nervous investors should be.
For bonds, the picture is more mixed. Bonds are likely to benefit if inflation fades, although our forecast of inflation volatility suggests it could be an uneasy ride in the medium term. But at least yields on US treasuries and UK gilts have now risen to levels where investors are getting paid to hold them. This is obviously good news for charities requiring income. And we still see a big role in portfolios for long-dated inflation-linked bonds, which stand to benefit if investors start to fear that inflation will rise once again in the medium term.
By the same token, cash is at last paying interest, even if real returns are still negative. But the main reason for holding cash is to preserve capital to put to work if a crisis forces holders of risky assets to divest at fire sale prices. This dynamic appeared briefly in the aftermath of former UK Chancellor Kwasi Kwarteng’s ill-fated mini-Budget, highlighting the importance of cash on hand to deploy, as opportunities may only appear for a few days before disappearing.
Overall, we think current conditions require an active approach which can preserve capital and then deploy it rapidly to take advantage of any emerging value in markets. And we would certainly place an emphasis on liquidity – vital if the inflationary oasis proves to be a mirage.