- Inflation has peaked but could stay elevated
- Interest rates expected to remain high
- A balanced portfolio will be the best option
After a year of dramatic rises, many analysts now believe that inflation has peaked and will moderate from hereon in. However, any reduction in inflation is likely to be slow, and interest rates may remain high for the rest of this year at least.
“It’s still too early to expect a rapid pivot to cutting rates, and a lopsided portfolio mainly invested in growth stocks could continue to face headwinds,” says Rob Morgan, chief analyst at Charles Stanley.
“Indebted companies are going to find the going tough, especially in areas sensitive to consumer demand, which could tail off as we go into recession. But valuations are much more realistic now and take account of the inflationary backdrop, so a balanced portfolio that includes some inflation hedges is likely to be far better equipped in 2023 than it was last year.”
Another reason to have a balanced portfolio is because risks are skewed in different directions: long-duration assets could struggle because inflation doesn’t come down as quickly as expected, but could also do well if price growth comes under control and market concerns are focused on recession.
“You need to construct a portfolio with both these outcomes in mind and in regard to prevailing valuations, which following a terrible 2022 for markets are attractive in many cases,” explains Morgan. “A balanced portfolio of equities, primarily invested for quality and dividend growth, and bonds, alongside some more inflation-resilient assets such as infrastructure and energy equities, ought to be well placed. The downside is that the middle ground will not be directionally right in either of those scenarios. However, it is better to be consistently about right than absolutely wrong in any one period.”
Bonds for the current environment
In 2022, rising rates led to a re-pricing across most major asset classes. Morgan believes that the bond market is more realistically priced for the current inflationary environment than the equity market. “Assuming inflation does trend downwards, there are significant opportunities at this juncture,” he adds.
Some fixed-income investments also tend to do well in the early stages of recessions. “Fixed income assets display better value than we have seen for a long time and now offer both reasonable return potential and useful diversification benefits within mixed-asset portfolios,” says Paul Glover, chief investment manager at NFU Mutual. “Higher-risk fixed-income assets have attractive yields, but the weakening economic and corporate outlook could see spreads widen further, so government bonds and cash may provide the best options as we enter 2023.”
But Morgan doesn’t think that index-linked gilts are a good option – especially longer-dated issues, which do not necessarily do well even when inflation is high. This was the case last year when, for example, the Investment Association (IA) UK Index Linked Gilts fund sector average return was a fall of -35.3 per cent.
By contrast, “short-dated index-linked bonds and US Treasury inflation-protected securities look reasonably attractive and should offer something of a hedge against short-term stickier inflation,” says Morgan.
Ben Seager-Scott, head of multi-asset funds at Evelyn Partners, argues that inflation-linked bonds more broadly are starting to look interesting again because “central banks are becoming less hawkish while inflation breakevens [measures of expected inflation] have fallen significantly and there is the potential for these to pick up a little this year. So adding some exposure seems sensible, but I wouldn’t hold significant proportions.”
However, deciding how much to put into different types of bonds and when you should adjust your allocations is difficult. So a good option can be a strategic bond fund, which invests in many varieties of fixed income, allowing its managers to focus on the areas that look best and avoid the less desirable ones.
Options include Janus Henderson Strategic Bond (GB0007502080), which aims to outperform the IA Sterling Strategic Bond sector average, after the deduction of charges, over any five-year period. The fund invests in bonds globally but if they are denominated in currencies other than sterling it hedges its exposure to remove the risk of exchange rate movements. The fund has an ongoing charge of 0.7 per cent and had a 12-month yield of 3.5 per cent as of 17 January.
But strategic bond funds can be higher risk than traditional corporate bond funds because they can invest in areas such as high-yield and emerging market bonds.
For equity exposure, David Henry, investment manager at Quilter Cheviot, suggests turning to the US because its economy and consumers appear to be in a better position than some other regions, and he thinks that it might even avoid recession. He suggests getting exposure via a fund that takes a value investment approach – ie, seeks to invest in stocks that appear to be trading for less than their intrinsic value.
He likes BNY Mellon US Equity Income (GB00BGV53J55), which has a “deep value strategy”. It had 28 per cent of its assets in financials, 16.4 per cent in healthcare and 12.8 per cent in energy at the end of November. The fund has an ongoing charge of 0.82 per cent.
But as risks to equities include recession or a slowdown, Seager-Scott says it is important to be diversified within your equity allocation. “Recent years have seen quite a narrow set of stocks perform disproportionately well, helped by ultra-low rates and negligible inflation, but I think we could see a broader range of winners in the future,” he explains. “So diversify not just by geography but also by sector and style.”
For higher-yielding and more defensive exposure, Trojan Global Income (GB00BD82KQ40) aims to generate income with the potential for capital growth over three to five years. As Charles Stanley analysts comment, the fund’s preference for “solid, reliable businesses”, that offer higher returns on capital and operating margins than peers, means it tends to do better, relatively speaking, in tougher economic times:
The fund tends to be fairly concentrated and only had 33 holdings at the end of November. It has an ongoing charge of 0.9 per cent.
Alex Brandreth, chief investment officer at Luna Investment Management, notes: “One fund that helped portfolios in 2022 and is worthy of consideration is LF Ruffer Diversified Return (GB00BMWLQT53).”
This fund launched in September 2021 and used alternative investment strategies such as derivatives to help mitigate downside in 2022. It aims for a positive return with a focus on capital preservation in all market conditions after costs and charges, over any 12-month period. At the end of 2022, it had about two-thirds of its assets in bonds, with some exposure to equity and gold investments.
Morgan likes the inflation-linked revenue streams delivered through infrastructure funds that invest in areas including renewable energy and battery storage. Options include Renewables Infrastructure Group (TRIG), which invests in onshore and offshore wind, and solar power in the UK and Europe. It had a yield of 5.25 per cent as of 16 January and an ongoing charge of 0.97 per cent.
For property exposure, TR Property Investment Trust (TRY) mainly invests in property securities listed in Europe and the UK, but also has 8 per cent in directly held commercial property investments. Brandreth has added to property and infrastructure assets lately, believing they now offer good value.
Henry suggests trimming commodities exposure, because this area did very well last year, but doesn’t tend to outperform in recessions. Yet he still suggests holding some gold. Ways to get exposure to it include iShares Physical Gold ETC (SGLN), which owns gold bars and has a net expense ratio of 0.12 per cent.