Given the current very high levels of inflation we wanted to share our views on the issue and discuss how we are positioning the portfolio to withstand these pressures. Please note that this article is our opinion within the Treasury and Investment Office (T&IO) and should not be treated as advice.
We think that inflation could peak this year as expected, but that it will likely remain volatile, with risks skewed to the upside over the medium-term. The extent to which we may be seeing a regime shift in inflation will become clearer with time, however, in the intervening period we must continue to guard against its pernicious impacts on the real value of our portfolios.
The strategic asset allocation has over recent years made a focus on ensuring a diversified basket of assets with positive, medium to longer-term inflation hedging characteristics. This should mean that the portfolio is well placed for this period of heightened pricing pressures.
To determine this allocation we assess the inflation mitigation properties of different asset classes through three separate channels: the assets sensitivity to inflation - its inflation beta, the stability of the inflation protection offered by the asset and the added risk-return costs and benefits.
This approach biases us toward an allocation to real assets through both infrastructure and real estate. Historically these assets have provided a degree of protection against inflation because rents and lease payments adjust in line with rising prices and capital flows into the asset class. Our scale and long-term investment approach means that many of these investments are held directly in high quality assets, which have a closer correlation to inflation than indirect investments such as REITS.
We also maintain a higher equity exposure than many of our peers. Equities are traditionally viewed as having some inflation mitigating properties because companies are able to raise their prices to match inflation. Typically this is strongest for companies operating in more inelastic markets such as energy and materials where costs can more easily be passed on to consumers.
Inflation and rising interest rates pose a particular challenge for fixed income. We anticipate that with the inflation outlook uncertain, volatility within government bond markets will increase. Our allocation to fixed income is much lower than many peers. Our exposure within the asset class has for some time been to reduce duration exposure, and invest in areas of the market that provide an additional level of return over pure government bonds.
This approach means that our bond exposure is biased toward credit risk. In addition to owning public debt we also have holdings in private credit where we can benefit from both the credit risk and an additional liquidity premium. Furthermore, private debt is typically issued at a floating rate and so can offer some protection from inflation as well as rising interest rates.
Overall our view on inflation is best summed up by the words of Milton Friedman’s dictum, “inflation is always and everywhere a monetary phenomenon.” This view has not changed, but there are clearly pressures in both the short and medium term that could mean prices remain elevated for longer than anticipated. By allocating to areas of the market that provide a premium along with inflation mitigating properties we believe that the portfolio is well positioned to withstand these pressures.