How inflationary pressures are affecting fund positioning – Interview with Richard Woolnough

Q: Richard, what is your assessment of the global economy?

The global economy has started to recover strongly from the damaging effects of COVID-19. Governments and central banks took decisive and necessary action in the form of proactive fiscal policy and maintaining interest rates at very low, even zero and below levels, to support spending and confidence. Of course, a consequence of an economy that is rebounding with such force is rising inflation, in the form of higher commodity prices, more spending on consumer goods, and rising wages.

One area of the economy that is under scrutiny, as growth picks up and interest rates remain accommodative, are labour markets. We are close to full employment in a number of economies and the so-called ‘quit rate’ – people voluntarily leaving their job – was at an all-time high as recently as September. We believe a very vibrant labour market will potentially result in higher wages and more sustained inflation going forward.

Q: Given this reinflationary environment, and that inflation can typically be a drag on bond markets, how is the fund positioned?

Firstly, let us consider the roles of duration and credit. Despite rising inflation, central banks remain ultra-accommodative, with interest rates close to zero. In this environment, as long as central banks lag inflation, we believe credit markets should remain well supported, because default rates will likely remain low. We have been shifting away from US dollar investment grade corporate bonds mainly into European corporates as we find the latter more attractive. In particular, we are focused on banks – they offer a wide range of opportunities, in our view, from highly-rated paper to high yielding subordinated bonds. Also, banks are tied to the economy, so tend to do well when economies improve.

From a duration perspective, we believe that the combination of monetary and fiscal stimulus could result in higher growth and higher inflation. This in turn will put pressure on government bonds. Moreover, government bonds don’t offer a favourable risk/reward as rates are generally close to zero, therefore offering limited upside in their price. In this context, we maintain a low duration positioning in our fund compared to the wider market.

There are some other tools we can use within the flexible approach of our fund, which give us the freedom to move between different fixed income asset classes (investment grade, government bonds and high yield), and even into equities (a maximum of 20% of total assets). We have favoured equities issued by companies operating in cyclical sectors, which traditionally benefit from an improving economy. This includes consumer discretionary, energy and healthcare sectors. 

We have also been active in inflation markets - buying or selling government bonds indexed to the inflation rate (index-linked bonds) as we try to gauge the path of inflation in the coming period. For example, last year we added long-dated US TIPS (Treasury Inflation-Protected Securities) as they were pricing in a very low inflationary environment. This was inconsistent with our view. This year, we have focused more on Japanese and eurozone linkers. We reduced exposure to the latter just recently as inflation in the eurozone has surprised to the upside and inflation expectations have risen significantly. We have also introduced an underweight position in UK inflation using derivatives.

Q: From October 29, the fund became an ‘Article 8’ classified fund under the new Sustainable Finance Disclosure Regulation (SFDR) introduced by the European Commission. Can you explain what this means in terms of fund portfolio changes?

An important change this year has been the classification of the fund to an ‘Article 8’ fund under new EU regulation. From October 29, we follow a positive ESG tilt approach, aiming to deliver investors a weighted average ESG score above that of its benchmark. The fund will also broaden its norm-based ESG exclusions, e.g. companies in breach of the United Nations Global Compact (UNGC) principles, and the government bonds issued by countries assessed as “not free” by the Freedom House index.   

Q: In the context of inflationary pressures, what is your view on the economy for 2022?

We continue to maintain a positive outlook for economic growth for the rest of the 2021 and into 2022. But a consequence of this is inflation – as discussed above - and we believe it will end up being higher than what we have been used to in previous inflation cycles, and also more permanent. We are therefore wary of holding too much duration and cautious on getting caught up in overvalued corporate bond markets, although we continue to look for attractive opportunities, particularly in Europe and UK markets and in sectors such as financials.

The main risks that could affect performance of the fund

• The value and income from the fund's assets will go down as well as up. This will cause the value of your investment to fall as well as rise. There is no guarantee that the fund will achieve its objective and you may get back less than you originally invested.
• Investments in bonds are affected by interest rates, inflation and credit ratings. It is possible that bond issuers will not pay interest or return the capital. All of these events can reduce the value of bonds held by the fund.
• High yield bonds usually carry greater risk that the bond issuers may not be able to pay interest or return the capital.
• The fund may use derivatives to profit from an expected rise or fall in the value of an asset. Should the asset’s value vary in an unexpected way, the fund will incur a loss. The fund’s use of derivatives may be extensive and exceed the value of its assets (leverage). This has the effect of magnifying the size of losses and gains, resulting in greater fluctuations in the value of the fund.
• Investing in emerging markets involves a greater risk of loss due to greater political, tax, economic, foreign exchange, liquidity and regulatory risks, among other factors. There may be difficulties in buying, selling, safekeeping or valuing investments in such countries.
• The fund is exposed to different currencies. Derivatives are used to minimise, but may not always eliminate, the impact of movements in currency exchange rates.·       ESG information from third-party data providers may be incomplete, inaccurate or unavailable. There is a risk that the investment manager may incorrectly assess a security or issuer, resulting in the incorrect inclusion or exclusion of a security in the portfolio of the fund.
• Further details of the risks that apply to the fund can be found in the fund's Prospectus.
• The views expressed in this document should not be taken as a recommendation, advice or forecast.

The fund allows for the extensive use of derivatives.

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