The likelihood of rising inflation over the medium term shouldn’t deter investors from adding to their portfolios although they should be conscious of the potential risks, according to a selection of industry professionals.
These views come after the Office for National Statistics (ONS) announced on Tuesday that the Consumer Price Index remained at 0.6 per cent throughout August, despite the fact many economists predicted this figure would have increased slightly.
While the temporary halt in inflation will have provided some with relief – particularly those invested in fixed income or who are holding cash – a number of industry commentators warned investors not to rest on their laurels.
“It looks as though inflation is going to be a story for 2017, rather than 2016, although there is evidence that weaker sterling is beginning to have an impact already,” Towrie’s Andrew Wilson said in an article published on Wednesday.
“The Chancellor and the Bank of England will be keen to avoid a “stagflationary” environment in 2017 and 2018, although even that would be preferable to a genuine inflationary pulse, which might require investors to build portfolios entirely different to those they have now.”
Given the sense of unrest when it comes to inflation risk over the medium term, FE Trustnet asked a number of investment professionals how they believe investors should position themselves to minimise the impact it will have on their portfolios.
Mike Pinggera, who co-runs the Sanlam FOUR Multi Strategy fund, says that we are in one of the most historically uncertain periods of investing to-date and that investors need to choose which asset classes they invest in carefully.
Performance of sectors in 2016
Source: FE Analytics
“It seems to me that, particularly with the very low interest rate policies the central banks are following, that thinking short-term is worth nothing,” he said.
“We’re in a real bind where we all accept we have a lot of uncertainty and, generally what you tend to do in periods of uncertainty is batten down the hatches and become very defensive, which translates in many cases as holding lots of cash and waiting for an opportunity. But, the central bank policies make that a really horrible position to be in.”
“The obvious place where we get long-life assets, we get near term cash-flow and we get some inflation linkage, is in the real asset area.”
More than 20 per cent of Sanlam FOUR Multi Strategy’s portfolio is invested in physical assets such as infrastructure, renewable energy, student accommodation and commercial real estate – the latter of which was added to the fund post-Brexit given market sell-offs in the area.
Since the start of the year, the fund (which resides in the IA Targeted Absolute Return sector) has returned 3.85 per cent while achieving less than half the annualised volatility of the MSCI AC World index.
“If you look at Neil Woodford’s fund, it is bigger than the entire listed infrastructure space, which probably tells you that the sector is still under-owned by a lot of people given the sector has been around for more than 10 years and has done really well,” Pinggera continued.
“I think inflation is a creeping thing, an interest increase everyone sees and a lot of people feel that as their mortgages go up, but inflation is there in the background and it’s a slow erosion of your savings.”
“I don’t see that the short-term inflationary impact is an obvious thing for investors to focus on but, over the long term, should we start to see a pick-up in inflation and it will become more painful with time.”
One asset that is particularly hard hit when inflation rises is fixed income as it eats into purchasing power and therefore the value of the investor’s real return.
That said, the latest data from the Investment Association – which covers the month of July – shows that fixed income funds were the best-selling asset with net retail sales of £1.1bn.
The asset class has indeed done well and particularly in the UK, with the IA UK Gilts and IA Sterling Corporate Bond sector averages comfortably outperforming the FTSE All Share index year-to-date.
Performance of sectors vs index in 2016
Source: FE Analytics
David Katimbo- Mugwanya, fixed interest fund manager at EdenTree, warns that bond investors should be concerned given the current inflationary risks on the horizon.
“I think some inflation is good. The ideal target banded around by central banks is 2 per cent so there is some kind of pressure needed for normal inflation, particularly when it comes to wages. Wages haven’t necessarily grown for some time so that coming through can’t be particularly positive for the economy,” he pointed out.
“However, in terms of markets and fixed income markets especially, inflation is not your friend because, if you’re earning a fixed rate of interest and inflation happens to eat into that, you’re making less real yield. Nominal yield might be high, but in terms of real yield, you make less.”
“That has different implications depending on where you are invested – for government bonds, for cash and for corporate bonds.”
The manager says that, given cash virtually offers investors no return and that government bonds have been heavily distorted by central bank policy, corporates and inflation-linked corporates are the best areas of the bond market to be invested in at the moment.
“Corporate bonds offer a greater spread than government bonds, but even so corporate bond yields are at a historic low. In terms of fixed rate bonds, you’re best protected in corporate bonds because of the higher yield element.” he explained.
“I would say inflation-linked is traditionally the best place to be to shield yourself against inflation. The market looks quite rich given where we are right now – central banks have piled in and yields are virtually negative across government inflation-linked bonds. Negative yields aren’t necessarily the best thing for investors looking at nominal total return numbers.”
“If you’re looking at it from an inflation-linked cash-flow perspective which is what pension funds would do, that would be your place to go.”
“From a capital perspective, yields are ultimately going to rise from their lows. From that angle I would say investors should be concerned. Where they have to hold fixed income assets, however, I don’t think there’s much of an alternative. It’s more about positioning yourself in shorter-dated end of the spectrum rather than chasing yield at the longer end of the curve.”
When it comes to equities, however, the picture looks rosier for those who are worried about the impact inflation will have on their portfolio.
Redington’s Nick Samuels points out that inflation expectations are more important when it comes to asset classes where returns are linked to CPI and have a floating rate element.
As such, he reasons that other factors such as valuation, liquidity and fundamentals should take precedent over inflation concerns among given that share price behaviour bears little correlation.
“Ordinarily one would expect companies with strong pricing power to do well in an inflationary environment as they can pass on the extra costs to their customer base. However, these companies are also classified as high quality, and tend to exhibit lower volatility characteristics as well,” he said.
“As such they have enjoyed spectacular share price returns in the low interest rate, low inflation environment we’ve had post the global financial crisis. Most firms with these characteristics are at or close to all-time relative high valuations and they may well mean revert during a period where inflation begins to creep up, and interest rates move up from their emergency levels.”
“If inflation is driven by rising commodity prices, you could see recovery-type funds do well, as they have large allocations to such areas at the moment, or indeed, dedicated commodity sector funds could do well.”