8 min read 31 Mar 21
Summary: We are at a critical juncture, where changes to the interest rate and inflation regime can determine the long term characteristics of investors’ portfolios. Importantly, the reasons why one or both are rising can be just as important as the levels yields may reach.
Inflation is back on investors’ radar screens. It feels like every commentator is dusting off their forecasting models to let us know what will happen next.
That this comes so soon after a year when the follies of forecasting were highlighted in brutal fashion is no surprise. The human tendencies for short-termism and storytelling are hard to resist.
As always, plausible cases can be made for either viewpoint. As always, trying to profit from a forecast-led approach means not only getting inflation outcomes right, but having a different forecast to everyone else, and factoring in all the other factors that can drive asset prices.
We should be wary then of building portfolios around a single view of the future. Given the frequency with which consensus forecasts are surprised (consider the deflation fears that dominated this time last year) it is better to consider the compensation on offer for all possible outcomes that are out there, not just the topic that has driven asset prices in the past month.
But while we should be wary of forecasting the prospects for inflation and interest rates, we cannot ignore them. These forces are defining drivers of the returns characteristics of investors’ portfolios.
We have previously discussed how falling interest rates and inflation in large parts of the world have resulted in a strong investment background environment for many portfolios over the past thirty years.
It is no surprise then, that any signs of an end to this environment should prompt some worried responses:
Source: https://www.msn.com/en-us/money/markets/investors-now-fear-inflation-and-the-fed-more-than-covid-bank-of-america-survey-shows/ar-BB1eDUpl?ocid=BingNewsSearch , https://www.bloomberg.com/professional/blog/the-inflation-regime-change-is-already-upon-us/ , https://www.reuters.com/article/us-usa-investment-inflation-analysis-idUSKBN2BF0DC , https://www.ft.com/content/afc414f9-c6a1-4f37-afab-276d98973a09 , accessed 29 March 2021
The emotional nature of these responses will also be driven in part by the speed of recent bond market moves, and so it is important to step back and consider the potential longer term implications of rate increases upon multi asset portfolios.
In much of the recent narrative, policy rates, rates set in the market, and inflation are often conflated.
However, for investors holding a portfolio of different asset types, the interplay between these forces are extremely important. The reasons why rates are moving are critical to determining the ultimate implications for different asset classes.
For most of the period since last summer, rising yields on long dated government bonds have gone hand in hand with strong returns from many equity markets and sections of the corporate bond universe. At the same time, there was little move in nearer term expectations for policy rates, as shown in the purple phase below:
Source: Thomson Reutiers DataStream, 30 March 2021
This was a ‘benign rising rate environment,’ where higher yields are associated with a more positive outlook for global economic growth. It may also have been associated with a simple improvement in investor risk perceptions as the panic of March 2020 abated.
We’ve seen such phases in the past, sometimes including periods in which policy rates were also rising, for example in the late 1990s, the early to mid-2000s and between the middle of 2016 and 2017. In these cases, improved expectations for profits growth or investors’ greater willingness to tolerate volatility outweigh the rising rate effect and can bring gains in ‘riskier’ assets.
Importantly, in these phases inflation is either less relevant as a factor driving higher rates (for example when there is a simple shift in risk perceptions), or the inflation is seen as being associated with stronger growth. Even if real profits growth is weak, the ability for companies to keep pace with inflation can make them an appealing asset relative to cash and certain bonds.
By contrast, a ‘malign rising rate environment’ is one in which the higher interest rate effect swamps any improvement in growth beliefs.
Either policy makers are seeking to slow growth to stave off inflation threats or prevent asset bubbles, or investors simply seek higher compensation for risk in all assets.
In this situation, there can be correlated weakness across most major asset classes, as in the periods we have heard a lot about recently: 1994, the ‘taper tantrum’ in 2013, and in 2018, when we discussed the correlating impacts of rates.
These are the types of phase that were echoed in mid-February. Yield increases weren’t limited to the long end of the Treasury curve but also in shorter maturity bonds and TIPs:
Source: Thomson Reuters DataStream, 30 March 2021
Against this backdrop most major equity and bond markets weakened together, and ‘growth’ and financials stocks proved an unlikely safe haven:
Source: Thomson Reuters DataStream, 30 March 2021
In these environments most assets suffer correlated declines. Far from rate sensitive assets providing the ‘insurance’ investors have been used to for much of the last thirty years, they are in the eye of the storm. Some types of stock can behave differently, as Aswath Damodaran discussed last week, including a reversal of much of the pattern of behaviour we have seen over the last decade.
We have subsequently seen a recovery in many parts of the equity market, but fears of the ‘malign’ environment still linger in investor psychology.
Should we see sustained periods of ‘malign’ rate increases, there can be few places to hide for investors, and if these rate moves are associated with higher inflation (as they typically are) then even cash can be dangerous.
Over the years, investors have come up with numerous rules of thumb to deal with such environments:
Different Asset Types
All these assets can have a role to play but we must avoid lazily assuming that they will provide the protection investors need.
If an asset is expensive in its own right and other investors are overpaying for the protection it might offer, then they can disappoint even in inflationary scenarios.
The drivers of return are never one dimensional. For example, inflation-linked Treasuries still lost money in the last month because bond market volatility manifested itself in rising real rates, even if inflation fears dominated commentary. Similarly, the inflation protection provided by commodities like gold is arguable, and we only need to look at recent phases of commodity price appreciation against a deflationary backdrop, to question simple rules of thumb.
As well as individual asset classes, investors need to consider how different approaches to asset allocation and active management can behave in different scenarios.
Different approaches will result in differing balances between exposures that can ‘protect’ or ‘grow’ in particular scenarios.
As we have discussed frequently in recent months, the prevailing valuations of most major asset classes are currently far less attractive from a longer term perspective, while the tactical opportunities presented by the volatility in 2020 have largely unwound.
From this position, an ability to be flexible in terms of selection and to dynamically change portfolio characteristics to profit from short term ‘episodic’ volatility could well be important in generating returns in the period ahead.
The value of investments will fluctuate, which will cause prices to fall as well as rise and you may not get back the original amount you invested. Past performance is not a guide to future performance.