The potential for an inflationary surprise could spell bad news for poorly prepared multi-asset investors, according to Hermes’ Tommaso Mancuso (pictured), who warned that bonds will do nothing more than disappoint investors in this scenario. 
While central banks are expected to tighten monetary policy gradually, the head of Hermes multi-asset warned that increasing confidence from the likes of the US Federal Reserve could mean tapering is rolled out quicker than expected.
As such, he said investors must remain quick-footed and adaptable in order to protect their money on the downside while generating stable returns.
“Economic activity is picking up across the globe, and inflation is starting to rear its head,” Mancuso said. “Major central banks are gradually tightening monetary policy but are at pains to avoid derailing the recovery.
“To continue supporting the economy, they are expected to act in a measured way and communicate their intentions clearly to not surprise the market.
“But in recent statements, the Federal Reserve seems to be less data-dependent and more confident about normalising policy over the medium term.”
Hermes’ research also shows that many asset allocators have reduced their exposure to equity beta (the sensitivity relative to benchmark volatility) compared with their positioning at the end of the previous market cycle.
The Hermes head of multi asset said this depicts a heightened level of caution among investors, despite the fact the global economy is undergoing one of the longest economic recoveries in history.
“Our own base case is for the market to remain supportive of growth assets into 2018,” he continued. “However, the longer the current market conditions persist, the more conscious we must be of the implications of a regime shift – and an inflationary surprise could be the trigger.”
During previous cycles, investors have rotated out of higher-risk equities and into the relative ‘safety’ of bonds if their confidence has waned.
Following years of ultra-loose monetary policy, however, bonds yields were pushed to historic lows and the asset class began exhibiting similar levels of volatility to equities last year, as shown in the below chart. What can also be seen is that, year-to-date, the gap between the performance of asset classes has indeed began widening once more.
Performance of indices over 10yrs
Source: FE Analytics
In fact, LGIM’s Daria Kuzina explained in a blog post last week that, while asset classes have correlated on occasion, she doesn’t believe this will have a lasting impact on cross-asset class correlations in a rising bond and equity environment.
“What we have seen post-crisis is really a continuation of the new ‘Millennium era’ (after 2000) of negative stock-bond correlations, which generally shifted to lower averages compared to the ‘bad old days’ (before 2000),” she explained.
“Correlations might occasionally pick up, although we don’t believe the old higher averages are coming back any time soon.”
Mancuso, however, warned that investors shouldn’t rest on their laurels when it comes to asset class correlation and believes bonds could start to behave like equities once again over the medium term.
“Decades of stable and negative stock-bond correlations have led investors to repeatedly take a flight-to-quality path during periods of turbulence, and over time such investment narratives can be mistaken for absolute truths,” he reasoned. “In a moderate reflationary scenario, bonds would not only produce disappointing returns but would also act as an insufficient hedge, because the stock-bond correlation would most likely turn positive.”
The Hermes head of multi asset also pointed out that valuations across asset classes are currently expensive, despite his constructive outlook for markets.
Not only this, he explained that increasing geopolitical uncertainty – such as the rise of protectionism in some developed economies and the emergence of China as a superpower – could present itself as a headwind over the medium term.
“Finally, the financial system is becoming ever more complex – and with complexity comes fragility,” Mancuso continued. “Leverage in the system remains high and risks continue to be concentrated in fewer hands.
“Passive and machine-led strategies are now major market participants, fuelling momentum. This means that, just as in October 1987, May 2010, or August 2015, when arbitrary lines are crossed, the market is more likely to experience sudden volatility.”
In order to prepare its portfolio for this scenario, the multi-asset team at Hermes is using relative-value and curve trades across a range of commodities, credit, interest rates and equities. Mancuso said these strategies are part of the 41 per cent exposure to risk factors within the Hermes Multi Asset Inflation fund’s portfolio.
“These challenges require a forward-looking, agile and adaptive approach to risk management,” he said. “Our approach is to maintain our inflation hedges and our focus on liquid assets.
“We will also continue looking for alternative sources of de-correlation such as cross-asset momentum and relative-value strategies to maintain a balanced portfolio.”
Since its launch in 2014, Hermes Multi Asset Inflation (which has no specified benchmark) has returned 5.97 per cent.
Performance of fund since launch
Source: FE Analytics
It has done so with an annualised volatility of 4.2 per cent and a maximum drawdown – which measures the most money lost if bought and sold at the worst possible times – of 7.6 per cent.
The fund has a clean ongoing charges figure (OCF) of 0.59 per cent.