Focus Shifts to Inflation
Tideway Market Update, 01/04/2021
It is hard to find any market commentary right now that does not talk about the fear of rising inflation. How real is that threat and what can we do about it?
Inflation gets pushed up either when the costs of supplying goods and services rise (Brexit tariffs would be a good example here for UK inflation), or when demand outstrips supply and suppliers raise prices. Right now, save for the localised Brexit impact on the UK, it is the demand side which is causing the worries.
Except for his ‘senior moment’ trip on the stairs of Air Force One, Joe Biden has largely been out of the mainstream UK press, which is still focused on our impressive vaccine roll out. But Biden has been busy in his first 100 days rolling out and getting approved a $1.9trn Covid relief package, and yesterday announcing a $2trn infrastructure project. He might not be tweeting, but he is quietly getting a substantial relief and spending programme underway. This, and Covid fiscal relief and stimulus in other countries, combined with pent up spending demand as countries emerge from lockdowns, is what some fear will stoke inflation. In the US those earning less than $75,000 and couples earning less than $150,000 are about to receive a $1,400 “check”. This is free money, and many assume that it will be spent quickly thereby fuelling inflation.
Inflation is notoriously difficult to predict. Since the turn of the century many have been predicting that low interest rates, which give people and companies more money to spend as mortgage and borrowing costs fall, would cause inflation to rise. It did not happen and save for some brief up ticks it has been struggling to average the 2% target (both in the UK and US) set by central bankers as the ideal rate. In 2020 it fell again and is currently just under 1% in the UK and just over 1% in the US. Financial stimulus in the form of ultra-low interest rates have not caused inflation since the last great recession and therefore it is quite possible, counter to expectations, that the Covid “checks” will not either.
There are some who may rush straight to the local car show room and use the cheque on a down payment of a new car, but in 2020 car sales were down by over 15% in the US and it is not at all clear that they will bounce right back in 2021. We also know that plenty of people are saving and rebuilding their balance sheets with personal savings at record levels. When money gets saved rather than spent it tends not to push up inflation but does increase the demand for investment assets whose prices then rise. This appears have been a major factor in recent recoveries from recessionary events, keeping inflation low, but helping asset prices recover.
The infrastructure spend may be different, we will have to wait and see what impact this has, but in any event, it will take considerably longer for that impact to be felt.
We are constantly focused on inflation as we know it is a key concern for those living off their invested capital as most Tideway clients do or will be doing at some point. Even at a relatively benign rate of 2% a year over 10 years its going to knock 22% off the value of your money when you come to spend it. That is why we do not invest extensively in anything that returns less than current inflation after fees have been accounted for. We also have a strong focus on income as well as just capital gains, noting that regularly earned investment income takes the pressure off generating capital gains to fund withdrawals and cashflow needs, and helps us avoid having to sell assets in a downturn just to fund income needs.
These twin disciplines have a side effect which means that we are well positioned if, and we still think its quite a big if, inflation starts to rise. As Nick focuses below on the two exposed areas when rates rise, which are long duration Government bonds and growth shares, whose values predicated on far out future earnings. We have no exposure to the former and modest and measured exposure to the latter.
Inflation Protecting Portfolios:
As you will know, we categorise our asset classes into three broad strategies: Fixed Income, Alternatives and Equities. We will run through the contents of each of these underlying strategies with our thoughts about how increased inflation and higher yields would affect each of these strategies.
The first strategy, and perhaps the most important to consider when looking at inflation, is Fixed Income (you can also see this referred to as Bonds and Credit in some of our other literature). As the name suggests Fixed Income securities pay the holder a fixed amount based on the nominal value of the security. As inflation rises, these fixed income payments become less valuable, which in turn sends yields higher and therefore reduces the overall market value of this security. Furthermore, all other factors being held constant, the longer a bond’s maturity, the more vulnerable it is to increases in inflation, as cashflows further into the future become less valuable in real terms.
This concern for fixed income investors is real, though Tideway’s approach to fixed income selection; choosing to avoid government securities, purchasing Hybrid Capital and higher yielding securities as well as concentrating on those with shorter maturities, compares favourably in the conditions. Tideway’s duration exposure is weighted towards the shorter end of the yield curve which helps protect against the current rising yields at the longer end. Furthermore, short dated fixed income securities will also mature more quickly than longer dated securities providing cash and the potential for reinvestment in opportunities further out on the curve where yields are most attractive (higher) compared to their duration. This will in turn provide increased income for our investors over time and is a positive for these strategies as opposed to being stuck in a world of perpetually low yields.
Purely on a yield and duration basis, compared to longer duration government and corporate bond indices which we have discussed in previous communications, we are relatively well positioned with short term rates set to remain suppressed. Despite low duration, appealing yields are still available, even after adjusting for defaults. Sanlam Credit fund, which is a major part of Tideway portfolios currently has a duration of 2.71. With an effective duration of 4.98 the Hybrid Capital strategy is slightly longer dated but has shown resilience this year; the fund showing a negative correlation to rising US 10-year yields on both a 1- and 3-year basis with the manager expecting this trend to continue.
The second strategy in focus is alternatives, which in Tideway portfolios broadly translates to listed Infrastructure and Real Estate (Real Assets) through Legg Mason IF Clearbridge, Schroder Global Cities and Sanlam High Income Return funds. We think an investment in Real Assets is a natural place to be when it comes to protection against rising prices with inflation-linked contracts and the ability to pass through costs a feature of these Real Assets which are necessary for the functioning of the economy.
The revenue streams of infrastructure companies are often linked to inflation, which leads to their cashflows and dividends having a high degree of inflation protection. Quoting Shane Hurst, one of the managers of Legg Mason IF Clearbridge Global Infrastructure:
- Rising rates and accompanying inflation will have little impact on valuations of regulated assets in the medium to longer term if inflation can be directly or indirectly passed through to customers.
- User-pays assets typically see cash flows increase if there is a cyclical upswing in growth and interest rates, with increasing valuations more than offsetting the impact of a rising cost of capital.
- There appears to be little to no correlation between various infrastructure assets and inflation over the past 30 years.
As we wrote in a recent note, we do not see inflation as a challenge to this strategy as although previous instances of rising US bond yields have yielded some negative and neutral returns in the short term, once the yield peak is reached the strategy has subsequently enjoyed a period of very strong performance with changes made during these cycles contributing to performance. Although there may be some short-term volatility in certain assets, we believe the strategy will produce some excellent long term inflation beating returns.
We believe Schroder Global Cities, one of our other core holdings within our Alternatives strategy should also perform relatively well should the market get spooked by inflation with Global REITs displaying an historic correlation of just 0.07 with the US-10 year, however it must be noted that when inflation is particularly high it can suffer from a higher discount risk. Curbs to supply, tight planning regimes, barriers to entry all contribute to rising prices with landlords able to pass this on to tenants in the form of increased rents when contracts are up. Ability to capture pricing increases is dependent on pricing power; the ability to hold a finite asset whilst retaining demand from a healthy sub sector.
Equities is the last of the asset classes under consideration and broadly speaking has been a good hedge to inflation when it has been pro-cyclical. We have discussed at length, over the last eighteen months, the benefits of a balanced approach in our equity allocation rather than chasing gains in expensive technology or growth areas of the market and have seen the benefits post vaccine announcement in November. We will not repeat ourselves here but our allocation to value and more cyclical areas of the market has typically proven prudent in times of rising yields. In addition to our deep value managers, the following managers have been taking advantage of their more flexible mandates and positioning their portfolios, to varying degrees, towards a global reopening; Artemis US Select, Blackrock Emerging Markets, Artemis Global Income.
Overall, despite viewing rising inflation beyond what would be a sign of a healthier and less stagnant economy, as unlikely, we believe that we are relatively well positioned should this scenario occur. As Dario Perkins, Managing Director, Global Macro at TS Lombard puts best: ‘The good news for investors is that they don’t need to overthink this – since the “inflation trade” is really just an extension of the “reopening trade”. We have a portfolio of fixed income securities which are less sensitive to increases in rates than your traditional government or investment grade corporates, an equity portfolio which contains many strategies including exposure to pure value and cyclical strategies, including more tactical positions in the global reopening as well as allocations to strategies investing in Real Assets whose revenue streams are often linked to inflation, or are directly able to pass on increase in costs to the end user.
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