Inflation risks: Fine-tuning multi-asset investment tactics.Changing workforce demographics, Covid and climate change are pushing prices higher, leading to investment strategy shifts. Steven Hay, head of Income Research explains the forces at play.
All investment strategies have the potential for profit and loss, capital is at risk. Past performance is not a guide to future returns.
“Inflation is when you pay $15 for the $10 haircut you used to get for $5 when you had hair.”
For a while, it seemed like high inflation in developed markets had been confined to the history books.
For years we wondered if prices would even rise fast enough again to meet central bank expectations. But now above-target inflation is back in the headlines, and there’s growing concern it may stay that way for a long time to come.
There’s good reason to worry: inflation is a significant risk to investment returns. For anyone relying on a fixed income, one or two years of higher inflation is a bit painful, but a prolonged spell can profoundly dent their purchasing power. For a long-term income to be sustainable, it needs to be inflation-proof.
The Multi Asset Income strategy aims to deliver a resilient monthly income, while preserving the real value of income and capital – ie adjusting for price-level changes – so inflation risk is very much front and centre in our minds. We believe that the risk of a prolonged period of higher inflation is now much higher than at any point in more than 30 years.
All the time, we balance the need for high income today with investments that might not be the highest yielders right now but have the potential to deliver growing income over time. This should help ensure we meet our objectives and is the thing that many income investors ignore because they are too short term.
As we say, we invest for long-term income, not short-term yield. The higher risk of inflation brings the long-term outlook into an even sharper focus. And it makes us think harder about selecting investments that can provide enough income growth to keep pace with a rising cost of living.
Having nine different asset classes to choose from gives us a great degree of flexibility to move the portfolio towards asset classes that are likely to perform better in a world of fast price gains.
And as you would expect from Baillie Gifford, we have a real focus on investing in the right companies. For each investment case, we consider how the business would do in an inflationary scenario, for example, whether it has pricing power.
I have more to say on our strategy. But first I want to provide some context.
Before joining Baillie Gifford, I worked at the Bank of England, providing research to the Monetary Policy Committee, so I have some insight into how central bankers view the current dynamic.
And I’d like to explore both what’s causing prices to rise and how interest rate setters might react.
While anecdotes are no substitute for hard data, we are all aware of mounting inflationary pressure.
There are shortages of the ‘right type’ of workers in hospitality and logistics as well as the professional services. There will apparently be toy and turkey shortages at Christmas. What is going on?
In a typical recession, economic activity gets hit and a large rift opens between actual economic performance and what’s regarded to be its potential. Economists call this the output gap. Usually, government spending comes to the rescue and plugs the gap. This causes the fiscal deficit – the difference between government income and outgoings – to grow.
The UK output gap and fiscal stimulus
The pandemic presented a very different type of recession. Because of the many restrictions on activity, economic potential was hit almost as much as economic demand. Consequently, only a very small gap opened between actual growth and potential growth. Yet, more fiscal stimulus has been provided than in the global financial crisis of 2007–08.
We also need to remember there has also been a huge amount of monetary stimulus through quantitative easing. The Bank of England has printed £440bn extra money, amounting to nearly 25 per cent of GDP, and injected it into the economy. The extra liquidity is bidding up asset prices and will find its way into the price of everything.
If supply cannot expand to meet all this higher demand, we will get higher inflation.
The situation is even more extreme in the US, where the path of inflation is off the scale compared with the last two decades.
Core US price rises over course of a single year
The above graph shows accumulated price rises in consumer goods and services (but not food and energy) over the course of a year, illustrating how fast prices have been rising in the US this year compared to the experience of the past 20 years.
Taken together, the current cyclical inflationary dynamic is the strongest I can remember for many years and it is likely to light the fuse on rising inflation expectations.
In thinking about inflation’s long-term path, we need to look at structural shifts in the economy. We won’t get a sustained period of general inflation without wages growing. Otherwise prices would have to fall back after any rise as we would have only a limited ability to use savings to boost spending above our incomes.
Over recent decades, there has been a lot of downward pressure on wages from big structural forces such as globalisation, automation and demographics. But the key question is what happens next.
The percentage of the world’s population made up of those aged between 15 and 64 and willing to work (the working age population) has been falling for a while. Yet this has not translated into higher real wages. A key reason was globalisation. Manufacturing moved to lower-income countries with young, growing populations. The UK could access cheaper imports from first Japan, then Korea and Taiwan, and then China. Meanwhile companies outsourced services to the likes of India and the Philippines.
But there are grounds to believe that globalisation’s impact has peaked.
Globalisation is a hard concept to measure, but one way is to use global trade as a proxy. For many years, global trade accounted for a growing share of GDP. But this trend has stalled and maybe even gone into reverse.
Global merchandise exports as % GDP
One reason is that the one-off integration of countries like China and the ex-Soviet bloc into the global trading system has now happened and is not being repeated. It’s also the case that the political landscape has become less conducive to shifting production overseas. Tensions between the US and China, for example, are making CEOs think twice about relocating manufacturing. Another more recent trend is that the pandemic and climate change have pressured companies to source locally and keep their supply chains short.
In addition, global demographics are starting to resemble those of the developed world. Birth rates everywhere are falling, and the percentage of people within the world’s working age population is shrinking. While this might be mitigated by people working for longer, there’s a limit to how long people can stay in the labour force.
Working age population as a share of total population
Ultimately, we are coming from a deflationary period of increasing access to a growing global workforce, to a new reality where local labour market conditions matter more. If there’s a shortage of workers, then rather than outsource to an emerging market or bring in immigrant labour the only option may be to pay them more. And this will lead to inflation.
There’s a suggestion that automation might prevent workers' bargaining power from improving even though they might be becoming scarcer. Automation does of course have huge potential to replace labour and in the very long run it’s likely machines will be able to do most jobs. But while AI is making huge strides, I think the speed at which it can replace people is overestimated. It is not a significant enough force to keep the lid on inflation.
Central bank concerns
One could argue that while it is interesting to debate structural shifts, inflation’s path will ultimately be controlled by central banks: they have the toolkit and the know-how to manage an inflation spike and bring price rises back to their target.
But while the central banks will taper their asset purchases, they will find it difficult to fully lean against inflation. Tightening is easy when the economy is growing quickly. But they will find themselves in a tricky situation if inflation is too high and at the same time growth is faltering and financial markets falling.
Central bankers have not been in that position since the 1980s. And there’s two reasons they won’t find it that easy to tighten: the loss of fiscal discipline and society’s attitudes to inflation.
Governments have shown themselves willing to throw fiscal discipline out the window. Even after we move beyond Covid-19, climate change will require state investments in essential infrastructure to fight climate change. Global warming poses an existential threat that demands government action and justifies large-scale fiscal spending. If the result is higher inflation, central banks would be placed in the unenviable position of having to raise interest rates and stop buying government debt through quantitative easing programmes. And that would add to the already gargantuan cost of critical government programmes.
The UK’s debt is now so high that, according to the Office for Budget Responsibility, raising interest rates 1 per cent would add £21bn to the Treasury’s interest bill. That’s a lot of hospitals or grants for hydrogen boilers. Whereas a bit of inflation does wonders in eroding the real value of the government’s debt.
On top of this, the bigger question is whether society is anti-inflation anymore. Ultimately it is what society wants that determines inflation – remember that it is the government that sets the central bank’s objective.
Mechanically we know how to control inflation. The question is whether we are willing to take the pain required to do so. After the high inflation of the 1970s and 80s, there was a clear mandate from society to bring down inflation. I believe that has significantly weakened and people care more about the climate and inequality than they do about whether inflation is 2 per cent or 4 per cent.
So if central banks make excuses for why inflation is temporary and don’t respond, then inflation expectations will rise. And the longer they stay high the more entrenched they will become.
That could lead to a much longer period of higher inflation until central banks are eventually forced to respond more aggressively.
As mentioned at the start, the Multi Asset Income strategy aims to grow income and capital at least in line with inflation.
And we are leaning both on asset allocation and stock selection to prepare the portfolio for the risk of higher inflation.
The areas that are most negatively affected are government bonds and high-grade corporate bonds. These are nominal assets where you are not compensated for higher inflation. We have almost completely sold out of these asset classes.
Within fixed income, we prefer high-yield bonds and emerging market debt. High-yield bonds are relatively more attractive because their shorter terms make them less sensitive to inflation, but also because inflation erodes the real value of debt, which is especially helpful to companies with lower credit quality. And in emerging markets we are typically seeing weaker inflationary dynamics, so again having a global approach helps.
Instead, we have been adding to real assets – the term given to tangible things with inherent physical worth. This includes investments in infrastructure and property, where the cash flows are often directly or indirectly linked to inflation. Equities also offer protection against inflation, and we have been adding to holdings in gold miners. We think they will do particularly well in an inflationary scenario.
It is important to bear in mind that for every asset class, we invest in a bespoke income-oriented portfolio run by our colleagues at Baillie Gifford. That’s because we believe security selection is crucial to creating a long-term, resilient income.
In the inflationary world, we are paying particular attention to the ability of companies to pass on price rises. Take the example from our equity portfolio of Watsco, a distributor of energy efficient air conditioning units. It passes any price increases straight on to consumers and takes the same margin on a higher dollar volume, so periods of inflation have historically been very favourable to it.
While property as an asset class has a mixed record of protecting against inflation, residential property has attractive characteristics. Rental income is supported by employment income. So if wages are growing, rents can follow. Irish Residential Properties (IRES), an Irish residential-focused real estate investment trust, exemplifies this. It has supportive fundamentals with a strong urbanisation trend and barriers to new supply. These make its income growth prospects attractive.
In infrastructure too we have found investments that can protect against inflation. HICL Infrastructure has revenues from public-private partnership projects that are inflation-linked and from the public sector. These make it an ideal investment because it is resilient to both the economic cycle and inflation.
While we see the risks of higher inflation as material we don’t have all our eggs in the high inflation basket. Our portfolio should enable us to achieve the strategy's objectives even if inflation is subdued. It’s just that we have more of an eye than most on the risks from higher inflation.
Risk Factors and Important Information
The views expressed in this communication are those of Steven Hay and should not be considered as advice or a recommendation to buy, sell or hold a particular investment. They reflect personal opinion and should not be taken as statements of fact nor should any reliance be placed on them when making investment decisions.
This communication was produced and approved in November 2021 has not been updated subsequently. It represents views held at the time of writing and may not reflect current thinking.
Potential for Profit and Loss
All investment strategies have the potential for profit and loss, capital is at risk. Past performance is not a guide to future returns.
Any stock examples and images used in this communication are not intended to represent recommendations to buy or sell, neither is it implied that they will prove profitable in the future. It is not known whether they will feature in any future portfolio produced by us. Any individual examples will represent only a small part of the overall portfolio and are inserted purely to help illustrate our investment style.
This communication contains information on investments which does not constitute independent research. Accordingly, it is not subject to the protections afforded to independent research, but is classified as advertising under Art 68 of the Financial Services Act (‘FinSA’) and Baillie Gifford and its staff may have dealt in the investments concerned.
All information is sourced from Baillie Gifford & Co and is current unless otherwise stated.
The images used in this communication are for illustrative purposes only.
Baillie Gifford & Co and Baillie Gifford & Co Limited are authorised and regulated by the Financial Conduct Authority (FCA). Baillie Gifford & Co Limited is an Authorised Corporate Director of OEICs.
Baillie Gifford Overseas Limited provides investment management and advisory services to non-UK Professional/Institutional clients only. Baillie Gifford Overseas Limited is wholly owned by Baillie Gifford & Co. Baillie Gifford & Co and Baillie Gifford Overseas Limited are authorised and regulated by the FCA in the UK.
Persons resident or domiciled outside the UK should consult with their professional advisers as to whether they require any governmental or other consents in order to enable them to invest, and with their tax advisers for advice relevant to their own particular circumstances.
This document is suitable for use of financial intermediaries. Financial intermediaries are solely responsible for any further distribution and Baillie Gifford takes no responsibility for the reliance on this document by any other person who did not receive this document directly from Baillie Gifford.
Baillie Gifford Investment Management (Europe) Limited provides investment management and advisory services to European (excluding UK) clients. It was incorporated in Ireland in May 2018 and is authorised by the Central Bank of Ireland. Through its MiFID passport, it has established Baillie Gifford Investment Management (Europe) Limited (Frankfurt Branch) to market its investment management and advisory services and distribute Baillie Gifford Worldwide Funds plc in Germany. Similarly, it has established Baillie Gifford Investment Management (Europe) Limited (Amsterdam Branch) to market its investment management and advisory services and distribute Baillie Gifford Worldwide Funds plc in The Netherlands. Baillie Gifford Investment Management (Europe) Limited also has a representative office in Zurich, Switzerland pursuant to Art. 58 of the Federal Act on Financial Institutions ("FinIA"). It does not constitute a branch and therefore does not have authority to commit Baillie Gifford Investment Management (Europe) Limited. It is the intention to ask for the authorisation by the Swiss Financial Market Supervisory Authority (FINMA) to maintain this representative office of a foreign asset manager of collective assets in Switzerland pursuant to the applicable transitional provisions of FinIA. Baillie Gifford Investment Management (Europe) Limited is a wholly owned subsidiary of Baillie Gifford Overseas Limited, which is wholly owned by Baillie Gifford & Co.
Baillie Gifford Asia (Hong Kong) Limited 柏基亞洲(香港)有限公司 is wholly owned by Baillie Gifford Overseas Limited and holds a Type 1 and a Type 2 license from the Securities & Futures Commission of Hong Kong to market and distribute Baillie Gifford’s range of collective investment schemes to professional investors in Hong Kong. Baillie Gifford Asia (Hong Kong) Limited 柏基亞洲(香港)有限公司 can be contacted at Suites 2713-2715, Two International Finance Centre, 8 Finance Street, Central, Hong Kong. Telephone +852 3756 5700.
Baillie Gifford Overseas Limited is licensed with the Financial Services Commission in South Korea as a cross border Discretionary Investment Manager and Non-discretionary Investment Adviser.
Mitsubishi UFJ Baillie Gifford Asset Management Limited (‘MUBGAM’) is a joint venture company between Mitsubishi UFJ Trust & Banking Corporation and Baillie Gifford Overseas Limited. MUBGAM is authorised and regulated by the Financial Conduct Authority.
Baillie Gifford Overseas Limited (ARBN 118 567 178) is registered as a foreign company under the Corporations Act 2001 (Cth) and holds Foreign Australian Financial Services Licence No 528911. This material is provided to you on the basis that you are a “wholesale client” within the meaning of section 761G of the Corporations Act 2001 (Cth) (“Corporations Act”). Please advise Baillie Gifford Overseas Limited immediately if you are not a wholesale client. In no circumstances may this material be made available to a “retail client” within the meaning of section 761G of the Corporations Act.
This material contains general information only. It does not take into account any person’s objectives, financial situation or needs.
Baillie Gifford Overseas Limited is registered as a Foreign Financial Services Provider with the Financial Sector Conduct Authority in South Africa.
Baillie Gifford International LLC is wholly owned by Baillie Gifford Overseas Limited; it was formed in Delaware in 2005 and is registered with the SEC. It is the legal entity through which Baillie Gifford Overseas Limited provides client service and marketing functions in North America. Baillie Gifford Overseas Limited is registered with the SEC in the United States of America.
The Manager is not resident in Canada, its head office and principal place of business is in Edinburgh, Scotland. Baillie Gifford Overseas Limited is regulated in Canada as a portfolio manager and exempt market dealer with the Ontario Securities Commission ('OSC'). Its portfolio manager licence is currently passported into Alberta, Quebec, Saskatchewan, Manitoba and Newfoundland & Labrador whereas the exempt market dealer licence is passported across all Canadian provinces and territories. Baillie Gifford International LLC is regulated by the OSC as an exempt market and its licence is passported across all Canadian provinces and territories. Baillie Gifford Investment Management (Europe) Limited (‘BGE’) relies on the International Investment Fund Manager Exemption in the provinces of Ontario and Quebec.
Baillie Gifford Overseas Limited (“BGO”) neither has a registered business presence nor a representative office in Oman and does not undertake banking business or provide financial services in Oman. Consequently, BGO is not regulated by either the Central Bank of Oman or Oman’s Capital Market Authority. No authorization, licence or approval has been received from the Capital Market Authority of Oman or any other regulatory authority in Oman, to provide such advice or service within Oman. BGO does not solicit business in Oman and does not market, offer, sell or distribute any financial or investment products or services in Oman and no subscription to any securities, products or financial services may or will be consummated within Oman. The recipient of this material represents that it is a financial institution or a sophisticated investor (as described in Article 139 of the Executive Regulations of the Capital Market Law) and that its officers/employees have such experience in business and financial matters that they are capable of evaluating the merits and risks of investments.
The materials contained herein are not intended to constitute an offer or provision of investment management, investment and advisory services or other financial services under the laws of Qatar. The services have not been and will not be authorised by the Qatar Financial Markets Authority, the Qatar Financial Centre Regulatory Authority or the Qatar Central Bank in accordance with their regulations or any other regulations in Qatar.
Baillie Gifford Overseas is not licensed under Israel’s Regulation of Investment Advising, Investment Marketing and Portfolio Management Law, 5755-1995 (the Advice Law) and does not carry insurance pursuant to the Advice Law. This material is only intended for those categories of Israeli residents who are qualified clients listed on the First Addendum to the Advice Law.