Investment company managers reveal their inflation-busting strategies, expectations and outlook for price levels.
With inflation running at 5.5%1 and predicted to rise, many investors are concerned about the impact on their investments. To discuss how investment company managers are handling the situation, the Association of Investment Companies (AIC) held a media webinar today on the outlook for inflation, featuring Ben Ritchie, Manager of Dunedin Income Growth, Charlotte Yonge, Manager of Personal Assets Trust and Nick Brind, Co-Manager of Polar Capital Global Financials.
We spoke to investment company managers about their expectations for inflation going forward, the greatest risks posed by high inflation and how their companies are protecting shareholders from inflation. Their comments were collated alongside views from Hamish Baillie, Manager of Ruffer Investment Company.
Investment companies: protecting shareholders from inflation
Charlotte Yonge, Manager of Personal Assets Trust, said: “The primary objective of Personal Assets Trust is preservation of capital in real terms, so protecting against inflation is a critical part of that. The uncertainty surrounding inflation is at multi-decade highs, at the same time that nominal yields remain near historic lows. Notwithstanding expected rate rises across various markets, that spells a continuation of the current environment of financial repression – i.e. where yields in real terms are negative. We own US index-linked bonds, where we believe the risks of inflation are not fully priced in, and gold, the millennia-old currency which, unlike fiat currencies, cannot be printed. We are also very clear about investing in equities that have pricing power but where valuations are not demanding.”
Nick Brind, Co-Manager of Polar Capital Global Financials, said: “Financials, in particular banks, are the most sensitive sector to rising inflation to the extent it leads to higher bond yields and interest rates. The earnings of banks, all things being equal, are very sensitive to rising interest rates but also bond yields which would result in their earnings rising sharply, as loans are repriced and net interest margins widen. Polar Capital Global Financials has around 65% of its portfolio in global bank shares, primarily in the US, but also in Europe and Asia.”
Hamish Baillie, Manager of Ruffer Investment Company, said: “We have been positioning for an environment of structurally higher inflation for some time. Our principal tools to benefit from inflation are index-linked government bonds (31% of the portfolio) and gold (7%) but the story is more nuanced than this. These assets actually benefit from lower real interest rates rather than inflation alone. If nominal bond yields rise in tandem with inflation expectations then this dilutes the benefit of index-linked bonds. For this reason, we also hold interest rate protection (effectively hedging out the risk of bond yields rising) and some of our equities (such as UK financials) are beneficiaries of rising rates.”
Ben Ritchie, Manager of Dunedin Income Growth, said: “Overall for the companies in our portfolio, an inflationary environment is neutral to positive for their capacity to generate profits and distribute them to shareholders. We favour companies with pricing power and wide margins, well positioned to maintain or even expand profitability at a time when their revenues are growing well. Where we have more potential headwinds to manage is where companies have been trading on high multiples of profit and these then have the potential to contract in such a period.
“On balance, versus a FTSE All-Share quite geared to commodities and banks, inflation is likely a net negative for the portfolio in the near term. That all said, the second and third order effects of higher interest rates and inflation may well be slower growth or even recession, and drawing on previous experience, we believe our portfolio would be quite resilient in that event. Overall, I believe we are well positioned for the long-term, even if recent months have been more challenging.”
Nick Brind, Co-Manager of Polar Capital Global Financials, said: “If inflation does not trend back to the levels seen pre-pandemic, then we would expect central banks to raise interest rates higher than currently expected by markets. We believe this would have a material impact on equity markets and result in significant volatility as investors increase their exposure to companies they perceive as having pricing power or whose earnings benefit. Interest rates rising higher than expectations could also affect equity markets from the resulting rise in interest rates and bond yields.”
Ben Ritchie, Manager of Dunedin Income Growth, said: “In the first order inflation really impacts company valuations in two ways – firstly impacting their profit, cash and dividend generating capacity and secondly raising the interest rate at which those profits, cash flows and dividends are discounted. Inherently investors are having to balance the risk to valuations of higher interest rates with the near-term risk to earnings that comes from higher inflation. An additional medium-term complication is that many of the companies whose profits are most positively geared to a higher interest rate environment are also those most likely to be hurt by an economic slowdown. Likewise many of the commodity producers seen as inflation hedges are also inherently very cyclical businesses. If we do see a significant tightening in monetary policy then it is likely that growth will be more challenging and that will make a difficult environment for investors to navigate.”
Hamish Baillie, Manager of Ruffer Investment Company, said: “Every company will react differently to rising costs, but in the initial stages of rising inflation you want to be in those companies with pricing power. We also like those companies which are most sensitive to changes in economic growth as the initial move in inflation is likely to be accompanied by reopening and strong economic growth – energy and industrials are good examples.
“Perversely, the parts of the equity market most at risk are highly valued, quality blue chip companies. There is a false comfort blanket that these businesses will weather any storm. While they have some degree of pricing power, history shows us that this is more than offset by the potential fall in their expensive valuations. Investors often focus too much on how a company will perform operationally in an inflationary world and forget how painful a derating can be. Even if management do a superb job at maintaining profitability, if the market assigns less value to those profits (i.e. through a falling P/E ratio) then shareholders are going to lose money. Growth parts of the market are also likely to suffer from rising rates, as we have seen at the start of 2022.”
Charlotte Yonge, Manager of Personal Assets Trust, said: “The risks to equities in an inflationary environment are manifold. The most immediate risk likely comes from valuations contracting; an expectation of higher interest rates feeds into higher discount rates. Current valuation levels leave vast swathes of the stock market exposed and we are just starting to see the implications of this. The second, longer-lasting impact will be if inflation endures and cash flows are hit. This will be particularly painful for companies with low margins and high input costs, which lack pricing power. It will also hurt businesses with hefty reinvestment requirements as those capital expenditures are made at higher prices. The cash flows of businesses with long-life intangible assets, with strong margin structures and pricing power, are likely to remain the most robust but, if starting multiples are high, these stocks will not be exempt from valuation risk either.”
What are your expectations for inflation?
Ben Ritchie, Manager of Dunedin Income Growth, said: “I have no idea! Two years ago at the depths of Covid we were looking at negative oil prices and talk of deflation. Today oil is close to $100 and the discussion is of supercycles and a return to 1970s style inflation. I see our job as managing a portfolio that we believe is capable of proving resilient in both environments, seeking to participate in the upside opportunities that are presented to deliver good total returns through the cycle and consistent and growing dividend distributions. If we can do that then we can hopefully keep our investors happy.”
Hamish Baillie, Manager of Ruffer Investment Company, said: “Like a rising tide, inflation will gradually increase to a structurally higher level, but there will be receding waves along the way which will feel like the worst is past. At the end of the day, inflation is a behavioural phenomenon and if consumers and corporates are worried that their money will buy them less in the future then demand is brought forward which further pushes up prices and the cycle becomes self-fulfilling. The fact that this behaviour has found its way into wages and stickier parts of the inflation indices like food and housing costs indicates that it is here to stay for some time. The more worrying scenario is if people start to question whether paper currencies are really a store of value. When this happens, they will panic into real assets of which we think gold and government backed inflation-protected bonds are the ultimate safe havens.”
Charlotte Yonge, Manager of Personal Assets Trust, said: “The inflation over the past year has been driven by a handful of items – in the US, namely energy and vehicle prices. However, inflation is starting to gather a broader base and, in particular shelter costs (which comprise a third of the US CPI) are starting to rise at a faster pace. Wage inflation will be a key driver as to whether higher inflation sustains. Higher wages have the power to drive demand beyond pandemic-related support and Covid-induced supply chain bottle necks.”
Nick Brind, Co-Manager of Polar Capital Global Financials, said: “We have huge sympathy for anyone expected to forecast inflation going forward. US economist JK Galbraith described forecasters as falling into two categories, ‘those who don’t know and those who don’t know they don’t know’. We are firmly in the former camp and expect that current inflation forecasts are wrong but only time will tell by how much and in which direction.”
Where are you seeing opportunities?
Hamish Baillie, Manager of Ruffer Investment Company, said: “Despite the inflation narrative hitting the mainstream, longer-term inflation expectations remain subdued. Investors expect central banks to magically walk the tightrope between an overly indebted economy and the need to raise rates and, hey presto, inflation will return to central bank targets. This seems unlikely to us – the scope for central banks to raise interest rates without torpedoing the economic recovery is severely limited. As a result, longer-term inflation expectations will rise. Long-dated index-linked bonds will benefit from this and UK index-linked gilts are likely to perform best.”
Charlotte Yonge, Manager of Personal Assets Trust, said: “Following recent market movements, US index-linked bonds look somewhat more attractive. There are also select opportunities in stocks but valuations still have a long way to fall, and we retain a cautious equity allocation.”
Ben Ritchie, Manager of Dunedin Income Growth, said: “The best opportunities we currently see are largely buying more of what we already have in the portfolio. For the first time in a number of years we have companies with strong business models and solid structural growth prospects trading at valuations that imply some very attractive future returns. The rapid rotation within the market from growth to value could have further to run – but with a mid-term view I believe that investing in companies such as Aveva, Intermediate Capital Group and London Stock Exchange has the potential to yield some attractive total returns.”
Nick Brind, Co-Manager of Polar Capital Global Financials, said: “On top of the opportunity in bank shares, we are seeing a broad range of opportunities across financials including in the non-life insurance sector. These companies having suffered a ‘soft market’ are now benefiting from the increase in insurance rates and therefore an improved outlook for profitability but due to their defensive counter-cyclical characteristics have, until recently, lagged the recovery in equity markets from the lows in March 2020.”
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Notes to editors
- Annual CPI inflation for January 2022. Source: Office for National Statistics.
- The Association of Investment Companies (AIC) was founded in 1932 to represent the interests of the investment trust industry – the oldest form of collective investment. Today, the AIC represents a broad range of closed-ended investment companies, incorporating investment trusts and other closed-ended investment companies and VCTs. The AIC’s members believe that the industry is best served if it is united and speaks with one voice. The AIC’s mission statement is to help members add value for shareholders over the longer term. The AIC has 360 members and the industry has total assets of approximately £269 billion.
- Disclaimer: The information contained in this press release does not constitute investment advice or personal recommendation and it is not an invitation or inducement to engage in investment activity. You should seek independent financial and, if appropriate, legal advice as to the suitability of any investment decision. Past performance is not a guide to future performance. The value of investment company shares, and the income from them, can fall as well as rise. You may not get back the full amount invested and, in some cases, nothing at all.
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