At what point should we really start to worry about inflation? Driven by rising fuel and energy prices, the UK’s headline figure rose to 5.1% in November, the highest for a decade.
It’s a similar story in the US, where inflation hit a 30-year high of 6.2% in October. I’ve always sat in the transitory inflation camp, but there is no doubt it is far more embedded than many initially thought.
Inflation is the bogeyman for a balanced 60-40 portfolio of equities and bonds in the current environment. Why? Because the for the past four decades that 40% bond allocation has been held to offset falling equities – as well as offering a reasonable income/yield. That does not hold up in today’s markets, as inflation threatens the idea of bonds and equities moving in different directions.
I recently read there are some $16trn (£12trn) of negative yielding bonds globally. The German sovereign 10-year bond yields -0.3% per annum – effectively guaranteeing a loss.
Ruffer is just one of a number of groups that believes inflation is likely to be the single biggest risk in the coming decade. In a recent update it said the US 10-year yield moving to just 3% (as was the case in 2018) would cause a loss of some 15% to bondholders.
That’s why we’ve heard a lot of noise around Treasury inflation-protected securities, aka TIPS, in recent months. But clearly, they are not without risk either, as they are highly sensitive to interest rate movements, and we all know that is on the radar.
Rathbone Strategic Growth Portfolio manager David Coombs currently has a 6% holding in a US Treasury 0.25% TIP in his portfolio, having built the position up at the start of 2021 as he felt transitory inflation would be longer than the market felt.
David says any decision to hold them now must depend on whether you view them as a return driver or a risk reducer. He sits in the reducer camp and therefore he feels they still play a role as a diversifier in the asset class – “I might even lose money on them on a 12-month view, but I don’t really mind because I’ve also got 38% in US equities in the portfolio and I’m not buying TIPS at this level, having already made a reasonable profit.”
TwentyFour Dynamic Bond fund co-manager Felipe Villarroel says TIPS typically behave in a similar fashion as US treasuries (UST), the only exception being when inflation adjusts significantly higher.
If this happens the expected ‘gain’ due to inflation in the coupons and principal more than offsets the ‘loss’ due to nominal UST moving lower in price – as is the case in 2021, which has prompted a severe adjustment in inflation expectations in the US. The result is, the 10-year TIP has significantly outperformed nominal UST, returning 4%, while USTs have fallen 4%.
Villaroel says TIPS are likely to underperform next year given they have been one of the best-performing asset classes in fixed income, while nominal UST will move higher in yield.
He feels that for TIPS to outperform again long-term, inflation expectations should move significantly higher from here, at a time when they are near the record-high seen by TIPS since the market began 20 years ago.
We largely agree that the risk on TIPS far outweigh the rewards for investors at this stage. The real yields are deeply negative meaning if you buy them today you are locking into a guaranteed loss if you hold them to maturity.
Before investors go out and panic buy them at this point in the cycle, they need to ask themselves two key questions – the first is whether they think they can ultimately sell them to someone at a higher price (an unadvisable strategy) and secondly, whether they are very confident hyperinflation is coming and are happy to give away a large chunk of capital for protection.
Index-linked bonds also have incredibly high duration (which means they are even more sensitive to interest rates). This is because interest rises not only force the yield of bonds up (pushing prices down) but they also reduce inflation expectations – thus hurting the inflation protection.
We don’t believe hyperinflation is on the radar, simply because, if it were to go much, higher interest rates would rise substantially, which would almost certainly cool the economy.
The economy is so used to low interest rates that it's hard to believe it could really function if they went back to double digits. The one worry would be wage inflation – which we have started to see a few signs of – but it is still very early days.
If you want protection from inflation, you're better off looking for real assets which have cash flows tied to inflation. If we did approach 10% for inflation, I’d be looking at gold funds, like Jupiter Gold and Silver or Ninety One Global Gold, as a potential hedge.
Darius McDermott is managing director at Chelsea Financial Services and FundCalibre. The views expressed above are his own and should not be taken as investment advice.