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Shelve the inflation crystal ball and opt for one strategy fits all

04 April 2022

It is near impossible to forecast the direction of inflation with any real certainty or accuracy.

By Philip Matthews,

Wise Funds

Rising prices are quite rightly at the forefront of investors’ minds this year, with US inflation hitting a near 40-year high and the UK Monetary Policy Committee forecasting it will surge to 7.25% in the UK this spring. Broadly, it seems investors face three potential inflation scenarios.

Firstly, inflation may prove transitory after all. There are certainly indications prices will trend lower again, with drivers such as supply chain disruptions seemingly having peaked. However, various unknowns remain, including the impact oil price volatility and escalating geopolitical tensions – particularly surrounding Russia’s invasion of Ukraine – could have on inflation.

As such, another possibility is inflation remains elevated over the long term. Lastly, there is the scenario in which inflation accelerates even further, likely driven by a wage growth spiral. And with strong US and UK employment data emerging, there is weight behind this darker outlook.

While it is tempting as investors to reach for the crystal ball in a bid to predict which inflation scenario will take shape, and to hedge portfolios accordingly, this could prove a costly mistake.

It is near impossible to forecast the direction of inflation with any real certainty or accuracy – even the Bank of England has made a hash of this over the last six months, warranting a change of course in its monetary policy that saw the UK’s first back-to-back interest rate rise since 2004.

Instead, it seems prudent investors adopt a more diversified and defensive strategy that insulates portfolios against whichever inflation scenario emerges over the coming months. Such a strategy is still perfectly capable of generating attractive returns and resilient income over the long-term.

The value in value

One key adjustment investors can make to future-proof portfolios is to hold a greater number of traditional value winners. Most commentators expect interest rates to rise further in the US and the UK in 2022, with the Federal Reserve explicitly indicating it expects to raise rates three times this year.

As markets face the prospect of liquidity support reversing, a greater reliance will be placed on earnings growth in the near term to drive equity markets forward. Traditional value sectors, including banks, miners and energy companies, are well placed to outperform in this context.

They should benefit from the cyclical economic bounce back due from the pandemic recovery, as well as more directly from rising energy prices and interest rates.

This move also reduces exposure to growth stocks that appear dangerously overpriced and out of kilter with their true underlying value. While a reacceleration in the performance of growth is possible, investors with an income requirement must be able to hang their hat on something substantial where valuation is concerned.

Moreover, it is quite possible we will witness a sizeable ‘blowing off’ of the froth in large, overpriced tech names. Such a correction may not drag wider assets down with it, though. Just take the Dotcom bubble, for example, when there was a significant valuation sell-off for the inflated tech leaders, but many other sectors and assets continued to generate attractive returns.

Essentially, this was a market valuation bubble-pricking exercise that was divorced from the real economy – and the same thing is certainly possible in the current context. As such, diversifying portfolios to value winners can provide a good level of protection moving forward.

Defend and diversify

Another defensive play that can insulate portfolios against inflation is greater geographical diversification. Certain regions, including Africa and the Middle East, are generally less correlated to the reflation trend of developed world economies. If the price of a barrel of oil surges further, for example, these regions or more likely to be beneficiaries than suffer a negative impact.

We recently reduced our exposure to UK equities and opted to increase our equity allocation internationally for this reason. We added to our holding in the Schroder Global Equity Income fund and initiated a holding in BlackRock Frontiers, taking advantage of a particularly attractive valuation.

BlackRock Frontiers operates mostly in countries well-placed to perform in an uncorrelated manner to developed economies, including Kazakhstan, Saudi Arabia, and Kenya.

Investors may also benefit from increasing exposure to infrastructure assets. The overvaluation of infrastructure seems to have unwound over the course of 2021, with yields again attractive and the net asset value of trusts investing in the sector well-placed for growth.

In addition, infrastructure naturally provides a degree of insulation from inflation, given its regulatory protection and exposure to rising power prices.

We therefore initiated a holding in John Laing Environmental Assets, a fund invested in environmental infrastructure investments including wind and solar farms. The fund yields a healthy 6.6%, with much of the income inflation protected and supported by subsidies.

Having traded at a premium above 15% for a long time, we were pleased to invest at a more modest premium of 3% – just as rising power prices look set to drive asset values higher.

Finally, within a more defensive fixed income allocation, it is possible to ensure some inflation protection by investing into asset-backed securities and loans where coupons are floating rate and linked to rising interest rates.

We recently increased our exposure to the TwentyFour Income Fund, an investment trust that specialises in investing across the spectrum of higher-yielding asset-backed securities including mortgages, credit card debt, senior secured corporate loans and auto loans.

The quality of the team’s credit work gives us confidence the portfolio is well protected on the downside should default rates rise. Meanwhile, the fact that asset-backed securities use floating rather than fixed rate coupons offers a hedge against rising rates, should the reflationary environment prove more than transitory.

Philip Matthews is a co-portfolio manager of the TB Wise Multi-Asset Income fund. The views expressed above are his own and should not be taken as investment advice.

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