Cover story – Inflation Investor approaches
Dealing with this complex inflationary environment pre- sents obvious challenges, but there are ways out of the maze, says Railpen’s Williams. “Given the uncertainty around infla- tion, interest rates and other macro variables, we look for long-term investments that should prosper largely indepen- dently of the macro environment. “For more macro-sensitive investments we have made some alterations that could be described as conventional inflation- protection measures,” Williams says. But given his more upbeat inflationary position, he adds: “From this juncture it’s more likely that our focus on inflation- protection will be marginally reversed rather than increased.” On a marker of how institutional investors should respond, Trow says: “The key issue is how far bond yields rise. “I fear that many managers have continued to buy equities for a lack of a suitable alternative since bonds were an even bigger bubble,” he adds. “If the equity rally starts to stall and suddenly US treasuries are offering 2.5% to 3%, the case for de-risking will look more attractive.” For Jeffrey, it is taking risk out of the equation. “Our mantra remains the same: investors should hedge unrewarded risk and carefully manage rewarded risk.
“In aggregate, the pension fund industry has rarely been in better shape with the industry funding ratio up by more than 10% in the past 12 months,” he adds. “That improvement looks set to trigger further conversations about additional hedging of inflation risk for those who are uncomfortably exposed.”
Portfolio structure
Doyle notes that an investment portfolio should be built to deal with the stresses and strains of inflation. “Our investment approach is dynamic and takes account of the evolution of a constantly-changing backdrop. A more inflationary backdrop is just one of the developments that inform the shape and structure of the portfolio. “We have some inflation protection built into the real return portfolio through holding a significant equity allocation,” she adds. “Many of the companies held exhibit significant pricing power, an important consideration in a more inflationary world. In addition, many of our investments in alternatives, which form part of the return-seeking core, benefit from infla- tion-linked contracts.” However, Doyle adds that the most important attribute for a multi-asset investment manager will be to remain flexible, rec- ognising that the opportunity set will change as the sands shift within the market backdrop.
Although the revival of inflation concerns in the past 12 months is a reminder of the difficulties of predicating an investment portfolio on any single scenario playing out.
22 | portfolio institutional | February 2022 | issue 110
The idea is that Chinese manufacturing has changed the inflation landscape for the past 30 years, but might not continue to change it over the next 30. James Brooke Turner, Nuffield Foundation
“Few investors saw the 2008 crash coming, almost none saw the pandemic coming, and practically no-one was warning about inflation risks a year ago,” Jeffrey says. “‘Don’t predict, prepare’ is the message.
“The first step in preparation is to build a well-diversified port- folio, the second step is to think about the plausible risks and stress-test that portfolio accordingly,” he adds.
Institutional impact Moreover, until recently, equity markets have been impervious to inflation developments. “That makes sense if you think that the corporate sector is able to pass through cost increases to consumers, leaving their bottom line largely unaffected,” Jef- frey says. “There has been some significant sector rotation within equities towards value stocks. That looks set to continue as the inflation outlook heats up.”
The impact on the bond market is more direct, with upward pressure on gilt and US treasury yields, but the impact has been quite subtle: 30-year gilt yields, for example, are below the levels we saw last spring before the inflation picture changed. “Time and again, investors should have learnt that it is danger- ous to assume that yields continue rising in a straight line,” Jef- frey adds.
While inflation may drive volatility in growth asset portfolios, it’s worth noting that many defined benefit schemes will have had a strong 2021 in terms of funding level progress. This afforded the opportunity to de-risk schemes, reducing sensitiv- ity to inflation going forward: lower growth assets and higher hedge ratios.
“Investors who see inflation as the primary risk to their portfo- lio risk making investments in assets with poor risk-return profiles – like gold and inflationary-linked treasuries – at the
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