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Transitory proves transitory

3rd December 2021

This week, the chair of the Federal Reserve (Fed) Jerome Powell has made the executive decision that use of the word transitory when describing inflation is, well, transitory. The Fed have admitted to getting the description wrong as inflation has proven to be more persistent than expected. As a result, they have indicated that they may speed up the tapering of their bond buying program, and the market has also priced in that they will start raising interest rates sooner. The main surprise is perhaps the timing of this revelation given the emergence of the omicron variant, and the potential impact this may have in slowing economic activity in the shorter term.

We worry about inflation (as all investors should!) given the purpose of our jobs is to grow the wealth of our clients after the impact of costs and inflation over the medium to long term. Higher inflation makes the hurdle for achieving this objective higher. Historically, when inflation does run hot, asset classes that don’t have embedded inflation protection can suffer from de-rating as investors require a higher nominal return to compensate for inflation risk. For instance, conventional bonds which offer a fixed coupon and principal payment typically sell off. Expensively valued equities can suffer de-rating as the discount rates used to value them often rise in inflationary periods as central banks look to raise interest rates. Not a great environment for portfolios full of those traditional building blocks…

As Ben Mackie wrote back in July, we are not in the business of staring into crystal balls and trying to predict what the next inflation or GDP print is going to be. Neither are we reliant on a particular macro view playing out to generate returns for our investors. We are all about building well diversified portfolios full of assets that are reasonably valued and have differentiated, uncorrelated return profiles that when combined should deliver attractive returns through investment cycles.

Thankfully, our go anywhere approach means that we are not constrained to owning traditional asset classes which may struggle in a more persistent inflationary environment. We have no exposure to developed market government bonds, which offer investors a negative real return even with relatively low levels of inflation. We also have little exposure to plain vanilla corporate bonds given the spreads over government bonds are tight. Where we do have some credit exposure, it is short duration in nature and therefore better protected against the risk of rising interest rates. Elsewhere within fixed income, we have a preference for floating rate debt, which benefits rather than suffers as interest rates rise.

Within our Funds we have increased our exposure to alternative assets in recent months. Not because we have a view on inflation, but because we have been finding lots of new ideas in this space where we expect returns to far exceed bonds and large portions of equities in the coming years without taking on excessive risks, as Ben Conway outlined a couple of weeks ago.  Many of our alternatives offer inflation busting returns.

Within property and infrastructure, a number of our holdings benefit from inflation linked leases, which means our income rises as inflation does. For instance, all of Impact Healthcare REIT’s (owns a portfolio of care homes) leases have inbuilt inflation linkage, around 90% of Supermarket Income REIT’s (owns large omni-channel grocery stores) leases are inflation linked, and new holding Atrato Onsite Energy (installing and managing commercial rooftop solar panels) has uncapped inflation linked leases. But like most things in investment it is nuanced – some of our exposure is not directly inflation linked as often these contracts come with minimum and maximum price rises (typical range of 1-4%). In some sectors it makes more sense for contracts to be linked to open market rent reviews, particularly where a sector is in vogue with tight supply/demand dynamics or where the property managers are doing lots of property management to increase value and can drive rent increases well in excess of inflation.

We have exposure to ships, which have been big beneficiaries of the higher inflation environment over the past 12-18 months. Over 90% of global trade involves the use of shipping for transportation of intermediate and finished goods, so in an inflationary environment driven by strong demand like we have seen over the past 12 months, ship charter rates rise (and can do so very rapidly!).

Elsewhere our exposure to assets like music royalties, battery storage and digital infrastructure offer uncorrelated return profiles with structural growth drivers that should see their value increase at a faster pace than inflation over the medium to long term. Our battery exposure benefits when there is elevated volatility in power prices, and boy has there been elevated volatility in recent months. The more intermittent renewable energy as a percent of the overall energy mix, the greater the volatility in short term power prices.

Within equities, we have exposure to attractively valued regional equities that are cheap relative to their own history and their future prospects and are therefore at lower risk of de-rating in a higher inflation environment than some of the expensively valued large caps that dominate passive exposure to the asset class. There are lots of idiosyncratic return drivers in this exposure too, from corporate engagement opportunities within smaller companies in Japan and the UK, to technical opportunities in the Korean preference share market.

So, transitory inflation or not, we are confident that our Funds are well positioned to achieve their objectives of growing the real wealth of our clients from today over the medium to long term.

Dan Cartridge – Assistant Investment 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. HA4660.

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