Weathering inflation's rebirth requires diversification

James Brundrett explains why DB schemes should diversify in the face of a bleaker economic climate

clock • 3 min read
Weathering inflation's rebirth requires diversification

As inflationary forecasts grow gloomier, to weather this highly uncertain environment for asset prices, investors may wish to balance their portfolios with true diversification across traditional growth assets, defensive strategies and real assets.

Economists were surprised by the strength of inflation in 2021, which was especially evident in higher commodity prices and shipping costs. Then came the geopolitical shock of the crisis in Ukraine the following year, and the prices of commodities such as oil, natural gas and wheat spiked still higher.

Yet some of these are one-off factors that should eventually ease. Given the rare rises in commodity prices over the past 12 months, year-on-year inflation comparisons for 2023 are expected to be more favourable. Commodity prices are currently falling and are down about 10% from their peak due to declining demand and recession fears. Pressures in the supply chain may abate as societies learn how to live with Covid-19. For example, the cost of shipping a container from Shanghai to Los Angeles has fallen by more than 40% from its peak, although it remains elevated in a historical context

However, rising wages create the danger of high inflation lasting longer and could lead to a self-reinforcing cycle of inflation where wages chase higher prices.  Mercer's Dynamic Asset Allocation Committee leans towards the view that US inflation is peaking and that the US economy will slow down without going through a major recession. The views on the UK inflation and growth are more nuanced given the uncertainties around energy prices. In both the US and the UK, labour markets remain tight and wages keep rising which means inflation may take longer to come down the 2% targeted by central banks.

There remains a risk of stagflation or deeper recession in a grim mirroring of the high inflation and low growth of the 1970s. While not our central case, we expect investors will wish to guard against these possibilities. Gilt yields have already risen sharply in response to higher inflation after their multi-decade decline while the US stock market and others have fallen by at least 20% — the definition of a bear market.

Therefore, defined benefit pension funds and other institutional investors should consider constructing portfolios that can weather all conditions by diversifying across four building blocks.

These are real assets that are inflation-sensitive; defensive strategies that limit the danger of recession; growth-focused assets in the event that financial markets suddenly recover; and assets that are alternative diversifiers, with low likely correlations to others.

In terms of real asset inflation hedges, there are opportunities in long-lease property, inflation-linked gilts that have been getting cheaper and floating rate debt such as leveraged loans. Private debt and secured finance may also offer effective protection. Defensive assets would include low-volatility equities, some hedge funds and absolute return bonds. We are beginning to see that convertible bonds have defensive qualities because they pay a coupon even if the equity element does not perform well.

There is also an opportunity for conservative defined benefit funds to de-risk their portfolios. A number of schemes have seen steady or even improving funding levels as liability values have fallen at the same or greater rate than assets (as of 30 June 2022, FTSE 350 DB schemes were in surplus on an IAS19 accounting basis).

For some of these schemes, credit spreads have widened to such an extent that they are in the privileged position of being able to sell their traditional growth asset holdings — typically only about 15% of portfolios — and buy credit. By doing so, these schemes may be able to remove equity risk, achieve their required expected return and help deliver the cash-flows needed to pay future pensions, while stabilising funding levels.

What's clear is that inaction in the context of fragile economies is not a wise option. While a soft landing still seems the most likely outcome, the risk of a return to the stagflation and deep recessions of the 1970s cannot be ruled out. The good news is that today's range of complex investment strategies means there are more ways than ever to truly diversify portfolios.

James Brundrett is a senior investment consultant and partner at Mercer

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