Where to invest to stay ahead of inflation
The fixed income market has been hit in the last six months by the rapid rise in US Treasury and other developed market yields. While it may be too early to call this the bottom, some value is starting to crystallize in the longer-dated part of the market. US and UK investment-grade bond benchmarks are down between 10 to 15% year to date, and it is now increasingly possible to find very good investmet-grade bonds at attractive valuations. For this reason, we suggest selectively adding very high-quality credits with 4–6-year duration, which should benefit in an environment of decreasing inflation, slightly lower interest rate expectations, and even in a recessionary scenario should interest rates rise further from current levels.
On the flip side, if you are a firm believer that inflation stays sticky and rates move even higher, buying good quality floating rate bonds and TIPs may be a good option. However, it is important to note that they will not perform particularly well should this high inflation lead to a recession.
The equity market experienced even higher volatility this year, with some major developed market indices down between 12% and 25% year to date. However, there have been huge disparities between different sectors and individual companies. Many high growth technology companies with limited profitability/cash flow generation trading on high multiples have been hit the hardest and, in many cases, are down between 50-80% from their highs, while more traditional and often more cyclical “value” businesses have outperformed. Some of the key beneficiaries of this value outperformance have been commodity/mining exposed companies, but we would be cautious about this exposure going forward, as inflation leading to an economic slowdown would likely reverse the good performance of these stocks.
These large disparities have created interesting opportunities, particularly in certain growth sectors. While we would discourage investments in speculative tech businesses, we believe several high-quality companies with wide moats and an ability to pass on inflation are now trading at attractive valuations and are a good addition to many long-term portfolios.
One may also consider a small allocation to alternative investments, especially select macro-focused strategies. Macro hedge funds tend to be a good diversifier in difficult times, and they have proved their value again this year after posting positive returns year to date, beating many other asset classes. Gold is another example of a diversifying asset, which tends to do well in market sell-offs as investors seek uncorrelated hedges and stores of value.
What to avoid in the current environment
Emerging markets are likely to stay under pressure not only due to inflation and potentially slowing growth but also because of Covid disruptions lasting longer than in many other countries, as well as political uncertainties and social unrest induced by a significantly squeezed consumer. What we are witnessing in Sri Lanka may be just the beginning; widespread demonstrations, violence, and political turmoil caused by unprecedented food and fuel shortages and a severe economic crisis could become a serious issue in several other countries.
Specifically for UK investors, we would advise to think global and avoid domestic UK companies, especially any small or medium-sized businesses. Inflation in the UK is particularly high and combined with stalling growth, the prospect of prolonged stagflation is higher than in other markets.
Business size will also matter, not only in the UK but globally. Large-cap companies are more likely to be successful in weathering the current storm, from absorbing higher input and financing costs to a better ability to potentially pass some of the commodity price increases onto their customers.
Staying nimble and focusing on the long term
A huge amount of uncertainty together with a considerable amount of volatility does not make investing simple. We believe it is crucial to look through the short-term price movements and focus on long term returns, as well as to stay nimble and ready to take advantage of any new opportunities.