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The best asset class to protect portfolios from today’s biggest headwind

17 November 2016

A selection of multi-asset portfolio managers explain why they believe inflation is the biggest market risk at the moment and which asset class they think is best-suited to protect against it.

By Lauren Mason,

Senior reporter, FE Trustnet

Out of most major asset classes, ‘real assets’ have provided the best hedge against inflation surprises over a period of more than 20 years, according to research from Cohen & Steers’ Vince Childers.

The portfolio manager’s analysis comes at a time when inflation is one of the biggest topics of debate among investors, especially given that inflation unexpectedly fell by 10 basis points to 0.9 per cent last month, according to the Office for National Statistics.

However, Bank of England governor Mark Carney, alongside many economists, has warned that this trend won’t continue and will inevitably reverse over the next year. This is without mentioning the election of Donald Trump as the US president-elect, whose plans to expand fiscal policy have led many industry professionals to believe inflation will also rise in the States.

UK inflation rate over 10yrs

 

Source: Trading Economics

Historically, fixed income assets have struggled during periods of inflation given that bonds yields can’t keep up with rising costs.

While this would typically mean equities are the favoured asset class, many investors have been bearish on them given high valuations and heightened levels of geopolitical uncertainty.

When it comes to alternatives, however, some investors worry about illiquidity issues, high valuations or simply buying into an area of the market they are unfamiliar with.

Childers’ research looks at the accuracy of the market’s inflation outlook – in other words, expected inflation versus realised inflation – between 1991 and June 2016, as he warns that inflation tends to be the most damaging for stocks and bonds when it is unexpected by markets.

To do this, the manager (pictured) has looked at the sensitivity of returns across different asset classes to a 1 per cent upside surprise in realised inflation, compared to market estimates from the year before.

As seen in the below graph, his research shows that a blend of diversified real assets has outperformed its long-term average by 5.8 per cent for every 1 per cent of ‘surprise inflation’. In contrast, stocks and bonds both suffered below-average returns.

Sensitivity to unexpected inflation May 1991 to June 2016

 

Source: Cohen & Steers

“By historical standards, today’s rate of inflation is relatively low. But since the typical retirement savings plan will span multiple economic, market and inflation cycles, it stands to reason that long-term investors will see inflation move higher. For this reason, we believe that a portion of assets should be allocated to investments with a positive sensitivity to inflation,” he said.


“We believe [our data] is a strong indicator that real assets can serve as an effective inflation hedge without being dependent on inflation to produce strong returns.”

Mike Pinggera, who heads up the Sanlam FOUR Multi-Strategy fund alongside Johan Badenhorst, says inflation concerns combined with increased volatility across equity and bond markets has created a challenging environment for investors.

As such, he believes investors should consider investments from both a long-term and a shorter-term, tactical perspective.

Bonds will deliver a relatively low level of income, but may struggle over the longer term to keep pace with inflation. Equities will deliver a variable near-term income and have historically offered some inflation protection, but volatility will be high,” he explained.

“The third possibility, which is my preferred route, is to invest in alternative assets such as infrastructure, student accommodation and renewable energy which can provide a stable income stream with inflation linkage. Given the current uncertainties, long-term, high quality income producing real assets make an attractive home for investors.”

Performance of indices over 10yrs

 

Source: FE Analytics

Wanda Mottu, senior analyst at SYZ Asset Management, says adopting a flexible asset allocation approach is the best way to protect a temporary inflationary environment. For this type of scenario, she says equities and commodities are her favoured assets.

“The link between equity and inflation is somehow mixed as an increase in inflationary pressure might push interest rates higher, initially leading to de-rating in the stock market valuation (higher interest rates will lead to lower P/E). But this negative impact should only be short-lived and stocks should then perform well. Longer term equities have proved to be a good protection against inflation,” she said.  

Commodities (oil, industrial metals) will also benefit from rising inflation. Gold, which has to be considered as an alternative currency, will also be favoured in our allocation. Unhedged gold positioning should perform well, especially if currency depreciation is the main driver of inflation (as it is the case in the UK with the sharp depreciation of the pound). “

In regard to fixed income, she warns the asset class is likely to be hit by reflation and rising interest rates and, as such, says exposure to bonds should be decreased and duration lowered.

She adds that, although inflation-linked bonds are designed to hedge inflation risk, the real return on them might still be negative.

Redington’s Tara Gillespie says that very long-term investors or those saving for retirement should invest in riskier assets to protect against future expected inflation rates, given that higher inflation will increase the cost of living.


However, for those with a short-term time horizon, she believes that inflation-linked bonds could indeed be a good way to protect and maximise returns.

“Not taking enough investment risk can be as detrimental to achieving a retirement income goal as taking too much risk. In the later stages of the retirement savings journey, it is crucial to de-risk, but protecting against higher inflation can be done, to a certain extent, by investing in inflation-linked government bonds.”

David Katimbo-Mugwanya, fixed income manager at EdenTree, agrees that inflation-linked bonds could help with easing inflationary pressure on investors’ portfolios.

Generally speaking, though, he admits a rise in inflation will be unfavourable for fixed income assets.

“As base effects stemming from lower oil prices a year ago come to the fore, along with sharp currency weakness post the UK’s referendum vote in June, inflation is set to rise,” he said.

“Although this outcome would not bode well for the fixed interest asset class as a whole, given the consequent decline in real income, securities whose cash flows are designed to track inflation are poised to benefit.

“Increasing portfolio allocations to real assets, such as inflation-linked bonds, could be one way to cushion the blow of rising prices. This debt typically appeals to investors with longer-term horizons and has been well sought-after for purposes of asset/liability management. It should come as no surprise therefore, that prices have already began to move in anticipation of higher inflation.” 

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