For information purposes only. The views and opinions expressed here are those of the author at the time of writing and can change; they may not represent the views of Premier Miton and should not be taken as statements of fact, nor should they be relied upon for making investment decisions.
Well maybe not everything, but it certainly makes a huge difference to the investment landscape and clients’ expectations.
In our view, the era of sub-normal inflation is now over and the world is in the process of inflation and interest rates returning to their long-term norms. The market still disagrees, at least if you believe the implied rate of inflation from the bond market. The breakeven rate between index linked and straight Treasury bonds indicates the market expects a reversion to lower rates for longer.
A massive mistake?
There should be nothing to fear in this, a more ‘normal’ investment environment will see less of the distortions of the previous decade. Indeed, nominal investment returns could be materially higher. The nominal rate of return is the total rate of return earned on an investment before adjusting for any deductions. We are already seeing the impact of higher nominal returns on clients’ attitudes to cash, leading to perhaps the massive mistake of switching out of real assets at exactly the wrong time. Over the coming decade, higher returns could be available across the asset classes, and particularly in real assets such as equities, property and commodities.
Higher inflation provides both a challenge and an opportunity for investors. Many have forgotten the importance of inflation protection over past decades, which led to a focus on nominal returns. The focus maybe should always have been preserving and growing the real value of assets. This could be particularly important in the post-retirement market, where the value of retirement income can be eroded by inflation over time. An apparently attractive fixed income from an annuity might not look so good in terms of spending power after ten years of inflation.
A key takeaway
The main takeaway from a more normal inflation environment is that real assets could outperform fixed income, even from the current level of starting yields. Within fixed income, shorter dated bonds and even index linked look more attractive than the longer dated bonds, which did so well over the past couple of decades. The other important takeaway is fixed income is less likely to diversify an equity portfolio, indeed in the past fixed income and equity became positively correlated in periods of higher inflation.
If inflation expectations again start to rise over the coming months, index linked bonds may outperform other government bonds materially.
US CPI versus US long dated index linked bonds relative to government bonds
Source: Bloomberg, data from 31.01.2011 to 18.10.2023
A normal world
In a normal world, real assets have a clear attraction. Fixed income returns matching or beating equity was very much a feature of the anomalous period of quantitative easing (QE) and may not return quickly.
Within the universe of real assets, the hierarchy may change, higher rates mean the rate at which future returns are discounted is greater, leading to a narrowing of the valuation gap between growth and quality focused assets. Companies with pricing power may retain their valuation premium, monopolies could have even greater advantages.
Consequently, we expect the much-changed investment environment to continue and those who recognise the change to position themselves accordingly. In terms of portfolio construction, bonds may not work as a diversifier to the degree they did in the recent past. Better diversifiers of equity risk, in an inflationary period, may be commodities and for a UK investor potentially the US dollar. Money could be sucked into the dollar in times of stress, as it has more flexibility than other countries to raise interest rates as the world’s reserve country.
