Time to consider a multi-asset approach?We believe a multi-asset approach may be well suited to the current climate. There are various assets that have a direct link to inflation, including infrastructure and property. There's also a range of asset classes — from asset-backed securities (ABS) to emerging market (EM) local currency bonds — that history shows have indirect links to inflation.
By constructing a portfolio containing these assets, achievable in some cases through listed alternatives, we think investors can potentially achieve positive returns even if inflation remains elevated. In our view, this compares favorably to investing in traditional assets only, which often provide limited inflation risk mitigation.
Which assets might you consider?Renewable infrastructure
This includes wind/solar farms, hydroelectric, geothermal, energy storage and biomass power-generating facilities. We believe these assets could provide significant mitigation against inflation risk, as a proportion of their revenues are typically explicitly linked to inflation under subsidy regimes. Others, meanwhile, are implicitly linked as energy prices tend to rise with (and contribute to) inflation.
Social infrastructureSocial infrastructure refers to a range of services and facilities that meet local and societal needs. These include those relating to health service provision, education, recreation and emergency facilities. Given their strategic importance, a significant proportion of revenues are typically directly linked to inflation through concession agreements, regulation and contracts.
PropertyProperty can potentially provide a significant hedge against inflation riskas revenues tend to have direct or implicit inflation links. For example, social housing leases can contain high levels of inflation-linkage. Meanwhile, student accommodation usually has one-year rolling rent reviews that typically exceed inflation.
Special opportunitiesThis asset class incorporates a diverse range of investments that have the potential to be relatively resilient in an inflationary environment. Examples could include royalty streams such as those from music. Healthcare might also be unaffected by rising inflation.
Asset-backed securitiesAn ABS is a security collateralized by an underlying pool of assets that deliver cashflows, such as consumer debt, mortgage debt or corporate loans. They have the potential to provide good inflationary risk mitigation depending on the broader macroeconomic environment. If, as looks likely, central banks stick to their inflation targeting approach, then they will continue to hike interest rates to tackle elevated inflation. ABS is a floating-rate asset class (as opposed to fixed rate assets), so income should rise in line with interest rates. Of course, in some scenarios, underlying borrower defaults may nudge up a little, but this shouldn’t materially eat into returns unless there is a significant economic downturn.
EquitiesLike ABS, the prospects for equities depends on the broader macro backdrop. Typically, equity revenues rise in line with prices, while inflation erodes corporate debt. That said, weaker economic growth or a dramatic rise in interest rates could cause a fall in equities as company operations, profits and balance sheets come under pressure. Equity valuations are also often linked to interest rates over time with higher rates, all else being equal, a negative for valuations.
Emerging market local currency bondsDifferent economies’ interest rate and inflation cycles are rarely perfectly aligned. Many emerging markets raised interest rates during 2021. EM bonds are therefore starting at a different point to developed market bonds. EM bonds usually have higher yields and consequently provide some defense against inflation. Furthermore, low duration bonds will have relatively lower capital losses (compared to higher duration bonds) if yields rise. Currency moves are likely to be the primary source of volatility. However, an approach that expresses its position against a basket of developed market currencies with similar sensitivities to emerging markets, such as from energy costs, should help to mitigate such risks.
Developed market government and corporate bondsDeveloped market government and corporate bonds typically do badly when inflation rises. That’s because, for one thing, bond yields rise causing capital losses, and, for another, they provide a nominal yield that inflation erodes in real terms.
In our view, one way to try to navigate an inflationary world is through a broad mix of different assets. That includes those where underlying revenues have an explicit link to inflation and those where history indicates an indirect link. The challenge is to create the right balance of these assets within a portfolio. In doing so, we believe investors can potentially achieve positive returns even during periods of heightened and sustained inflation.
IMPORTANT INFORMATIONDiversification does not ensure a profit or protect against a loss in a declining market.
Investments in asset backed and mortgage backed securities include additional risks that investors should be aware which include those associated with fixed income securities, as well as increased susceptibility to adverse economic developments.
Property investments may carry additional risk of loss due to the nature and volatility of the underlying investments and may not be available for investment by investors unless the investor meets certain regulatory requirements. In considering the prior performance information contained herein, potential investors should bear in mind that past performance is not necessarily indicative of future results, and there can be no assurance that such investments will achieve comparable results.
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).