In Newton's latest column on defined contribution, Mark Hammond discusses strategies to protect against the return of inflation
As 2021 continues to unfold, the combination of highly accommodative monetary policy and increasingly loose fiscal policy is creating a brighter economic outlook, especially as Covid-19 vaccination programmes are rolled out. A backdrop of economies starting to reopen at a time when they are awash with stimulus, has inevitably sparked concerns that inflation will rise. This raises questions over the prospects for government bonds in particular. The rapid rise in yields seen during the opening part of the year has reflected worries that a surge in inflation could lead, in time, to higher interest rates.
With economies opening up this year, it appears inevitable inflation will look significantly higher than during 2020, when lockdowns stalled demand. However, what remains less certain is whether this spike will prove transitory or become more permanent, amounting in effect to a regime change to which investors will have to adjust.
Inflation is just one of several risks faced by defined contribution (DC) investors, and needs to be considered in the broader context of delivering good member outcomes. However, inflation is clearly a significant concern when taking into account that a key objective for schemes is to increase the real wealth of their members and to ensure that their savings pots keep up with the cost of living and support their lifestyle at retirement.
Possessing safe-haven qualities, government bonds have typically formed part of a traditional default solution, especially as members approach retirement. However, the potential return of inflation means investors in bond strategies unable to adapt to the changing backdrop may run the risk of seeing returns eroded over time. Investing in bond strategies that target an absolute rate of return could be one option for DC schemes, as long as the strategy selected genuinely has the capacity to generate its target return in a range of market environments. Flexibility to allocate assets to different areas within the overall bond markets as opportunities present themselves is especially relevant, as is the capacity to change geographic and currency allocations. An ability to flexibly reduce duration and protect longer-dated bond positions from inflationary risks will also be important.
Within multi-asset portfolios, we believe having the flexibility to harness a broad mix of return sources will be critical. For example, inflation protection can be found in assets such as renewable energy and infrastructure that have very little sensitivity to the economic cycle but which often have very strong contractual obligations to provide inflation-linked revenues.
Mark Hammond is head of institutional pooled funds at Newton Investment Management
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