The growing importance of alternatives in an inflationary environment

Inflationary environment

The key attribute for managing any portfolio, whether pre-packaged solution or bespoke, is to have genuine investment flexibility, with many levers to pull when it comes to positioning for different macro regimes.

Materially above-target inflation is one such backdrop that is novel to many investment professionals, and even some markets – the rapidly growing UK defined contribution (DC) pension market for instance. Living professional memory for most has been one of low inflation and ever-decreasing interest rates.

Many of us thought that the first rounds of quantitative easing (QE) in the Global Financial Crisis (GFC) would herald a world of much higher inflation. Not only were the historical precedents there; it also seemed the only expedient way of reducing the eye-watering amounts of newly minted debt that had been used by governments to tackle the meltdown in the financial system. But higher inflation did not come to pass… until now.

So, if interest rates have been generally decreasing since the late 1980s – accelerating into a world of low and even negative yields in recent years (Exhibit 1) – how are investors equipped to deal with the threat of sustained price inflation and central banks’ attempts to control it? The answer to this question should be considered from the perspective of both returns and diversification.

Exhibit 1: Government bonds yields have followed a multi-decade trend lower – until recently

Source: Janus Henderson Investors, Refinitiv Datastream, 1 January 1985 to 30 April 2022. Past performance does not predict future returns.

The inflation conundrum in the context of traditional asset classes

Looking across the asset classes available to investors in mainstream, liquid asset classes – equities, government bonds, investment grade/high yield corporate bonds, and emerging market debt – it is hard to see where genuine protection from higher inflation can come from.

Government bond, investment grade corporate bond and emerging market debt returns are driven by duration, particularly when yields are so low and spreads so tight. And while the inflation-linked bond market might seem the ideal refuge in these environments, the market is relatively small and hugely distorted by the activity of pension funds and their liability-driven investment strategies. High yield, while less duration sensitive, is a relatively risky asset, which currently promises little by way of real return. Few fixed income assets have been in positive territory over the past 12 months (Exhibit 2).

Exhibit 2: Positive returns have been scarce across fixed income recently

Source: Janus Henderson Investors, Bloomberg, 31 March 2021 to 31 March 2022, showing three-month and 12-month returns. HY is high yield, EM is emerging market, IG is investment grade, ABS is asset-backed securities. Past performance does not predict future returns.

Equities, however, can offer an implicit inflation hedge, in that earnings can keep pace with inflation so long as companies have reasonable pricing power. The problem is that many equities, especially the performance leaders of recent years, are very sensitive to rising interest rate assumptions and this tends to cause price/earnings (PE) multiples to shrink, given that there is less opportunity for higher real earnings growth. In other words, there is (often) an inverse relationship between valuation multiples and interest rates, aside from financials, which tend to benefit from higher rates.

Property can also gain from higher inflation, primarily through rental growth (Exhibit 3), so long as debt levels are sufficiently conservative that interest rate rises do not become problematic. But the issue remains of how best to access illiquid physical assets, such as office blocks and shopping centres. Investors have various options for this, from direct property funds and real estate investment trusts (REITs) to private equity funds.

Exhibit 3: Property rents have a strong link to inflation

Source: Supermarket Income REIT, Tritax Eurobox, Target Healthcare REIT, latest data as at 31 December 2021. Shows percentage of rent that is inflation- or index-linked. Past performance does not predict future returns. References made to individual securities should not constitute or form part of any offer or solicitation to issue, sell, subscribe or purchase the security.

What do alternatives have to offer?

We believe that many alternative asset classes could offer a way to protect against and even benefit from higher inflation. In our view, closed-ended funds, such as investment trusts, are a viable solution for most investors to access these less liquid, real assets.

Beyond property, many infrastructure investments – economic and social, including the fast-growing renewable energy and energy efficiency sub-sectors – have explicit revenue linkages to inflation (Exhibit 4). While valuations may be linked to interest rate expectations, revenues are often fairly insensitive, or even entirely unconnected, to the economic cycle, and tend to be contracted for very long periods.

Exhibit 4: Inflation is linked to the value of infrastructure investments

Source: Greencoat UK Wind, HICL Infrastructure, International Public Partnerships, latest data as at 30 October 2021. Shows the impact on net asset values (NAV) of a 1% move in inflation assumptions. Past performance does not predict future returns. References made to individual securities should not constitute or form part of any offer or solicitation to issue, sell, subscribe or purchase the security.

The property universe also includes various sub-sectors such as healthcare, supported living, logistics and the private rented sector, all with rent increases very closely or explicitly linked to inflation. In contrast to renewable energy assets where these rises are unlimited, rent increases tend to be capped, albeit at a relatively high level.

Commodities tend to perform well in times of higher inflation. Higher energy prices drive a higher cost of living. Gold, however, plays a slightly different role and we believe it acts as a good hedge against both inflation and deflation shocks, rather than simply higher inflation. This is because if higher inflation is met with higher real interest rates, gold – as an unproductive asset with no yield – looks relatively unattractive. Inflation/deflation shocks, in contrast, lead to concerns about currencies and general market instability, meaning gold’s store-of-value characteristics look very appealing.

Broadening the multi-asset toolkit

Hedge/absolute return strategies can play an interesting role during inflection points in markets, such as we are currently experiencing. Any strategy capable of profiting from bouts of volatility, especially when markets are confronted with changing market regimes, has potential value. At the end of long cycles, when the same dynamics have consistently worked for investors (growth equities, high quality bonds, etc), assets can become materially mispriced.

As previously noted, most bonds do not cope well with environments of high inflation and rising interest rates. However, the less traditional areas we consider tend to offer floating rate coupons, which can help to mitigate much of this risk – and can sometimes be a driver of higher-than-normal total returns. These instruments are typically senior-secured loans or asset-backed securities.

Finally, the inflation linkage within private equity, as with listed equities, is much more implicit rather than explicit. Companies delivering essential services and products are well positioned to pass on any higher costs they incur to do business. However, all things being equal, higher interest rates are likely to lead to P/E multiple contraction across public and private markets. Investors are left relying that any underlying private equity exposure can generate a decent level of earnings growth to offset any valuation fall.

A stagflation 1970s comeback?

We believe that inflation is currently the dominant risk facing investors across any asset class. If growth remains strong alongside high inflation, then mainstream equities can continue to perform, albeit almost certainly delivering lower returns than in recent history – the same applies to private equity. But not many assets thrive in environments where inflation is materially above central banks’ targets and growth is lagging. It is our view that an allocation to the alternatives universe, and specifically real assets, could prove valuable in this environment, particularly if we enter a stagflationary environment akin to the 1970s. While recession risks are still low as the economy continues to recover from the COVID crisis (and lockdowns), some warning signs are starting to appear, such as yield curve inversion.