Dewi John on the battle to find inflation-beating returns in the current environment
Beating inflation is a lot more challenging when it is running at more than 10% than when it is about 2%. The savings accounts with the highest rates are about 5%, so that represents a loss in real terms
Only two Investment Association (IA) sectors have delivered double-digit returns during the 12 months to the end of October: Latin America (29%) and commodities & natural resources (24.9%).
The top-performing funds in the former all have significant tilts to Brazil (at about two-thirds of their portfolios), and Latin America performance has been assisted by the rise in the energy sector during the year – something closely linked to the fortunes of the second-largest riser.
Performance chasing is not a great idea unless you’ve got good reason to believe that momentum can be sustained. Given persistent energy insecurity caused by the Ukraine war, energy prices are likely to stay ahead of historical averages, but the rich returns of 2022 will be tough to repeat. Nevertheless, conditions may continue to favour them.
A further 11 sectors have delivered positive returns during the 12-month period, although all below the rate of inflation, and four of these below 1%. Of the sectors in positive territory, two are high-yield bonds. With companies’ cost of capital increasing, lower-rated debt will be increasingly vulnerable to default, and investors need to be asking themselves whether the higher coupon will compensate for this.
Speaking of the bond market, what’s perhaps counterintuitive is the worst-performing sector: UK Index Linked Gilts (-34.3%). After all, you buy these for inflation protection. Inflation turns up and – Bam! – you get all the protection of a paper crown from a Christmas cracker. What went wrong? Short answer: UK linkers, as they are known, tend to be much longer duration than the broad fixed income market, which means they are vulnerable to capital loss as rates rise. So, while the global inflation-linked sector has a duration of 5.6 and conventional UK gilts 10, for UK linkers that figure is 18.2 – by far the highest for any bond sector. If UK rates stabilise and inflation remains elevated, then UK linkers should rebound significantly. One finds silver linings where one may…
In the autumn issue of Personal Finance Professional, I wrote that the value bias towards global markets had benefited the UK, which has a strong bias to traditional value stocks, but noted that the strong value rally in the first half of the year seemed to have run out of steam. That’s continued to be the case, though I am a little bemused as to why: high and rising rates punish growth and benefit value. Central banks are still in tightening mode. However, the clear outperformance for value in general – and UK value in particular – has not been sustained. Performance between value and growth has flip-flopped from month to month. The explanation could be that value tends to correlate to real interest rates (nominal rates minus inflation), so if and when inflation stabilises and nominal rates continue to climb, this should put some wind back in value’s sails.
My colleagues at StarMine noted that momentum strategies in September (based on analyst revisions and price momentum factors) outperformed value strategies (relative valuation using ratios such as price/earnings (PE) and intrinsic value using a dividend discount model). They also noticed that key developed market value indices are undervalued on a forward 12-month PE basis versus their 10-year average and should therefore do well given the current rate environment.
This indicates that there may well be more to come from value despite the murky third quarter. There are other ways to access this than the traditional domestic bias of UK equity income funds. We have noted that investors have increasingly been searching for equity income in international markets.
This could prove part of what Lipper analysis shows is a strategic and decades-long shift of UK portfolios from domestic to global equities: in 2003, Equity Global and Equity Global Income funds combined stood at £20.4m and their UK equivalents at £95bn, so global funds were 17.7% of total combined assets. By 2021, those figures stood at £271.7bn and £268.7bn, respectively. Global funds were 50.3% of UK and global equity assets combined.
A shift to global equity income has helped investors during the past year, as the IA UK Equity Income sector is down 6.1% during the 12 months to the end of October, while its global equity income equivalent has lost a much thinner four basis points during the same period (with Global down 9.4%).
The major uncertainty is whether equity markets have bottomed out. That’s not a wager I will be tempted by, as one of the most useful pieces of investment advice I have ever been given is that only monkeys pick bottoms.
Dewi John is head of research in UK & Ireland at Refinitiv Lipper