Many clients ask us how we’re positioning our portfolios in an environment of rising inflation and, in particular, what we think about index-linked gilts or US Treasury Inflation-Protected Securities (TIPS) in this context. 
Our base case is for strong growth, rising inflation and rising central bank rates, so we’ve been focusing on which assets might benefit in an inflationary environment.
Taking almost 20 years of data, the chart below looks at conventional US 10-year Treasury yields, US 10-year break-even rates (i.e. market expectations of inflation) and the yield on US 10-year TIPS.
It’s worth pointing out that conventional yields, less market inflation expectations, amounts to the real yield, or the yield on the US TIPS. This might sound blindingly obvious, i.e. that conventional yields, less inflation, equals real yields, but it reminds us that real yields aren’t just driven by inflation expectations, they’re also driven by conventional government bond yields.
The power of conventional US Treasury yields can be seen in the graph below. Importantly, inflation expectations (shown as US 10-year break-even) have broadly remained the same over the period (with some volatility around the 2007/2008 crisis), but real yields have been forced materially lower by the grind lower in conventional US Treasury yields.
In short, US TIPS have made material money, during a period when inflation expectations have remained broadly unchanged.
US TIPS are driven by more than just inflation expectations
Source: Bloomberg
More relevant perhaps for the current environment we face, in the period since January 2017, US TIPS yields have risen, despite inflation expectations rising, as conventional Treasury bond yields have also risen and, again, proved the more powerful driver. This is an often forgotten dynamic, with many investors assuming that if inflation expectations rise, these instruments will necessarily make money. This is an understandable assumption, especially as the instrument is entitled “Treasury Inflation-Protected Securities”, but the clue’s not always in the title.
Turning to the UK, index-linked gilts, which in many ways are similar to their US equivalent, are standing at a negative yield at the moment (unlike US TIPS). This means that, while the dynamics outlined above can lead to capital gain or loss before maturity, if held to maturity, investors will be guaranteed a negative real return.
Another reason often cited for holding linkers or TIPS, is that they provide some diversification to their conventional counterparts. However, the evidence is not particularly convincing and they’ve been pretty correlated for most of the last 20 years, in no small part because real yields have been driven by nominal yields.
In short, we don’t think of these investments as inflation protection instruments but, more accurately, as real yield instruments, and don’t find them particularly attractive in this environment.
Our concern is that higher conventional government bond yields could overshadow the ‘benefit’ of higher inflation expectations, especially with central banks on the journey from QE to QT (quantitative tightening).
Instead, we see equities providing more of a natural inflation hedge, as they generate nominal sales and earnings growth. Within equities, we continue to prefer financials and resources, and tend to avoid labour intensive sectors that have weak pricing power, such as retail. In bonds we remain short duration, with a bias towards good quality credit.
Anthony Rayner is manager of Miton's multi-asset fund range. The views expressed above are his own and should not be taken as investment advice.