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Inflation has changed the rules of the game

29th April 2022

If you had just been woken up by a true love’s kiss from a Sleeping Beauty slumber and saw the year-to-date -6.8% return from your passive 40/60 equity/bond portfolio, you would probably think “thank goodness I had 60% in bonds to protect me from a massive bear market drawdown in equities”. Afterall, it is the third worst drawdown in 15 years (behind the covid sell off and GFC) for the 40/60 cautious portfolio.

However, when inspecting the underlying return drivers, you might have thought that you had been kissed by a frog instead and were still asleep having a strange nightmare. The ICE BofA Global Broad Market Hedge, the bond component of that passive portfolio, is down -7.8%. That’s a greater drawdown than the -5.6% return from the MSCI World All Cap index.

In fact, the start of 2022 has seen one of the biggest drawdowns in history for bond markets, including the third largest drawdown in a century for the US 10-year Treasury bond. Wasn’t that supposed to be risk free?

We have warned about the return free risk that bond markets have been offering over the past 18 months see here, and the dangers that ultra-low starting yields would mean that bonds were unlikely to offer meaningful portfolio diversification benefits going forward. Inflation has been the catalyst for this theory to translate into reality.

With the US and UK inflation prints out earlier this month (8.5% and 7% respectively for the year to the end of March!!), central banks across the globe are being increasingly aggressive in signalling rate rises. Bond markets have been forced to react with sharply higher yields (with the notable exception of the Bank of Japan who remain committed to their programme of unlimited bond buying to cap the yield and try to stoke inflation in the economy, which is currently causing the yen to collapse). Rising bond yields have put pressure on equities, particularly growth stocks whose cash flows are skewed long into the future and are more sensitive to rising bond yields than more cheaply valued stocks.

Unsurprisingly given our views regarding frothy bond valuations, our funds have been lowly exposed to both fixed income markets (with the notable exception of a few months after the sharp covid sell off when credit spreads blew out to very attractive levels, and we aggressively bought) and expensively valued growth equities in recent years.

We much preferred (and still do prefer) to own alternative assets like property, battery storage facilities, music royalties, shipping and digital infrastructure. Many of these assets have defensive characteristics, low economic sensitivity, offer attractive yields and are uncorrelated to each other as well as to bonds and equities. They offer real cashflows from real assets, often with useful features such as inflation linked revenues. Importantly, these assets are conservatively valued using discount rates that weren’t reduced sharply lower in line with falling bond yields (unlike growth equities) and thus offered a significant yield cushion against rising interest rate expectations. This means we’ve been able to build genuine diversification into our funds at a time when the traditional portfolio diversifier of bonds has been failing. Year to date, our Vanbrugh Fund is down just -0.8% compared to the 40/60 passive portfolio down -6.8%.

The minimum objective for any investor is to deliver a positive return after the impact of inflation and charges over the medium to long term – ie to increase future spending power. If you don’t achieve this objective, you would have been better off spending your hard-earned cash than investing it.

Looking at the 1-year performance numbers for the IA Flexible, IA Mixed Investment 40-85% and IA Mixed Investment 20-60% Shares Sectors (the sectors our three funds sit in), there are 511 funds across those three sectors with at least one year worth of performance data to the end of March 2022. A staggering 78% of funds delivered a negative return when adjusted for inflation over the past year. Just 8% delivered a positive real return of +2.5% or above – including all three of our funds (Vanbrugh +9.6%, Distribution +10.8%, Global Opps +11.1%).

Obviously, 1-year is not the medium to long term. Looking at rolling 5-year periods to quarter end since Vanbrugh and Distribution launched (over 13 years and over 10 years ago respectively), both have delivered positive returns after inflation over every rolling 5-year period. Global Opportunities is 3.5 years old, so we don’t have longer term data yet, but it is also comfortably beating inflation since launch.

If bonds do not perform their role as defensive assets and are unable to deliver a positive real return, then there are huge implications for how the whole investment industry is structured. Most conventional bond funds were given low risk scores even when yields (and prospective returns) were at all time low levels and were thus material building blocks of most cautious portfolios. Perhaps recent market moves will lead some/many to reconsider how they evaluate risk. For us, risk is the probability of permanent capital destruction in real terms and is always a function of prevailing valuations for any asset.

Dan Cartridge – Assistant Fund Manager

This financial promotion is issued by Hawksmoor Fund Managers which is a trading name of Hawksmoor Investment Management (“Hawksmoor”). Hawksmoor is authorised and regulated by the Financial Conduct Authority. Hawksmoor’s registered office is 2nd Floor Stratus House, Emperor Way, Exeter Business Park, Exeter, Devon EX1 3QS. Company Number: 6307442. This document does not constitute an offer or invitation to any person, nor should its content be interpreted as investment or tax advice for which you should consult your financial adviser and/or accountant. The information and opinions it contains have been compiled or arrived at from sources believed to be reliable at the time and are given in good faith, but no representation is made as to their accuracy, completeness or correctness. Any opinion expressed in this document, whether in general or both on the performance of individual securities and in a wider economic context, represents the views of Hawksmoor at the time of preparation and may be subject to change. Past performance is not a guide to future performance. The value of an investment and any income from it can fall as well as rise as a result of market and currency fluctuations. You may not get back the amount you originally invested. FPC264

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