Invest with Purpose

How to Invest in an Inflationary Environment

For a decade now, the behaviour of investors appears to have been predicated on the belief that a sustained acceleration in future inflation is unlikely. But if we are now entering an environment in which expectations of inflation begin to rise, the implications for investors are likely to be game-changing. A portfolio that is appropriate for an inflationary world is likely to be vastly different to one which has excelled in the last 40 years of disinflation.

Protecting a bond portfolio

Rising real yields and inflationary pressures are a key concern for bond investors, and conditions are likely to remain challenging for many developed-market government bonds in particular over the coming months. However, these assets may regain a role in portfolio construction as more elevated yield levels create attractive entry points.

There are a number of ways in which investors can seek to protect their bond portfolios in a more inflationary environment. Holding shorter-duration bonds helps to reduce the sensitivity of bond portfolios to rising yields. Other tools include inflation-linked bonds, such as US Treasury Inflation-Protected Securities (TIPS), and floating-rate notes where coupon payments rise with central-bank interest rates. Straightforward derivative strategies can help to protect against heightened rate volatility. Analysing the shape of any changes in the yield curve also provides opportunities to generate returns.

High-yield corporate bonds may also offer attractive characteristics. These bonds tend to be relatively short in duration and have a credit spread, providing a cushion against rising yields. Furthermore, while the economy is in a growth phase, companies are likely to be more profitable, meaning that they can better service their debt, resulting in lower default rates and potentially a tightening of credit spreads.

Finding equity opportunities

In equities, some of the more cyclical areas that have been out of favour in recent years may be set to outperform. Many ‘growth’ businesses, the relative winners of the low-growth, post financial-crisis world, have been trading at high valuation multiples, while those more cyclical areas of the market that traditionally benefit from higher inflation and higher interest rates now appear much cheaper relative to history.

Where can these stocks be found?

We see opportunities within parts of the financial sector; some of the large US banks, for example, have recently grown their dividend payments by 40%, as well as undertaking significant share buybacks. Together with the potential for multiple expansion, this has the potential to deliver a very attractive total return. Elsewhere, for many companies in the energy area, markets appear to be discounting a swift move to cleaner forms of power and the rollout of electric vehicles. Nevertheless, we believe there will be a need for transition fuels for some time, and see opportunities in certain businesses where we are observing a real shift in how management teams are allocating capital.

A different multi-asset toolkit

From a multi-asset perspective, a more inflationary environment over the medium term is likely to have profound implications in terms of how different asset classes behave and are correlated, and this will have repercussions for the way investment strategies are constructed. With bonds not offering the diversification that they have done in the past, it will be important to ensure that portfolios still have liquidity, tail-risk protection and alternative capital-preservation tools. Convex long option and volatility strategies, such as risk-premia strategies with an asymmetric return profile, could help and, if structured effectively, the cost of hedging may not be prohibitive.

Analysis of inflationary episodes and the performance of different asset classes over the last 50 years shows that bonds generated negative real returns during most inflationary episodes, and equities as an asset class also frequently underperformed. Gold performed strongly during the inflationary periods of the 1970s, but appears to have been much less related to inflation since then. On the other hand, commodities that constitute the raw materials of production processes have had a much more reliable relationship to inflation, with a strong positive correlation between broad commodity prices and inflation. Renewable-energy infrastructure assets, whose revenues are often linked to the rate of inflation, could also be well placed to outperform.

Ultimately, we believe an active and flexible approach will be critical in seeking to take advantage of a changing opportunity set, underpinned by a sound risk-management framework.

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