As if their investment decisions are not difficult enough, fund managers have the added complication of deciding whether they are facing inflation or deflation.
Current market conditions of growing economic uncertainty, extremely volatile equity markets make investment decisions more difficult than ever.
Mawby says: “In the medium term, with absolute yield levels at or near historic lows, investment grade, corporate debt remains attractive on a risk adjusted basis. Corporates continue to have healthy balance sheets and strong profitability even in the face of economic uncertainty.”
In the longer term, Mawby says: “With the duration bubble seemingly in its final stages, floating rate product will become more attractive. As such, floating rate products will outperform if the underlying higher inflationary conditions start to become more permanent.”
Savary names real assets as a key solution – “but only in some countries” – and commodities such as gold, but avoid developed world debt.
Risk averse investors wanting 3.5% for the next five years, with inflation at about 3% or 3.5%, “have to find ways not to put themselves in the wrong investment – and Bunds are the wrong investment.”
Xiaowei Kang, director of global research and design at Standard & Poor’s, says: “Depending on investment objectives and constraints, investors who may be seeking a real asset allocation need not be handcuffed by traditional asset class boundaries, and may consider real asset-based equities as an alternative means of accessing commodities, real estate and infrastructure.”
S&P research suggests that over the last 15 years “real asset-based equities and commodity-based equities have significantly outperformed core equity indices and commodity indices, respectively, with comparable volatility.”
Nor do they lack portfolio diversification benefits, as many believe. Xiaowei says: “Correlation does not provide a complete picture of diversification potential.
Another important factor that impacts diversification is dispersion of asset returns. Since real asset-based equities often exhibit performance profiles that are distinct from those of core equities, they may provide a certain degree of portfolio diversification.”
Stefan Wundrak, research manager specialising in Europe at German property asset manager Warburg Henderson, says some property can also offer some protection, not least because owners can refurbish it to raise rents, in contrast to shares and bonds.
He notes some German property allows inflation-linked rental increases, after CPI over the life of the lease reaches 5%, for example.
Rudden says how much inflation protection to buy depends on one’s tolerance and sensitivity to it, but at least 10% allocation at all times makes sense.
His team’s research found optimal efficient frontier positioning, squaring off risk-adjusted returns and inflation-fighting, is roughly equal amounts in commodity-producing stocks, real estate shares and commodity futures. Valuations
or liquidity are guides to security selection at any one time.
Inflation-linked securities, commodities and commodity-linked stocks have higher beta to inflation, large caps typically are negatively correlated.
Agriculture stocks have no correlation, whereas industrial metals, energy and gold investments have protective relationships.
But sell large caps to rotate and your Sharpe ratio will fall, Rudden notes, as bullion and precious metal futures have Sharpes 30% to 50% that of equities.
But Invesco’s Greenwood does not believe real assets to be the right strategy in the current conditions.
Real assets might be appropriate in a hyper-inflationary environment, he says, such as that which happened in Zimbabwe, Brazil and Chile, when they had a combination of dictators and weak central banks.
“In the developed economies, we now have strong central banks with a remit to fight inflation.”
Inflation-linked bonds (‘linkers’) in developing markets can play a useful role in fighting inflation for investors willing to take exposure to emerging markets, says Ghidini, who manages Swiss & Global Asset Management’s JB Emerging Markets Inflation Linked Bond fund.
The government bond inflation-linked market in EMs stands at around $450bn.
The asset class is on a real yield of around 3.5%, while linkers in developed markets are showing real yields between nil and 1%.
The picture becomes even gloomier if you take the nominal yields and subtract the current inflation levels: implied real yields in US ten-year Treasuries and UK gilts are deep in negative territory – about -1% to -3% – bad news for bondholders in developed economies.
Mexico, Brazil, and even Uruguay, stand out as countries with compelling real yield levels of around 2.5%, 5.8% and 4% respectively.
The total returns since 2004 from unhedged, index exposure to the overall market has been about 150%. Ghidini notes the average 12% annual returns have come with about 12% volatility, so an allocator should be patient, and tolerant of volatility.