Global markets have been tense in recent weeks as investors kept a watchful eye for signs of higher inflation.
In April, as the UK inflation rate more than doubled to 1.5%, US inflation data showed consumer prices rose at their fastest pace in 13 years, pushing stocks to their worst day in months.
Are they good reasons to panic?
For long-term investors, and particularly those in funds that can adapt to changing market conditions by actively investing across multiple asset classes, the answer is no.
When looking at a client’s investments, their ability to accept a higher level of uncertainty in exchange for the possibility of greater returns, depends on three factors.
Firstly, there are the risks embedded in the client’s individual circumstances – for example, a freelancer whose income is uneven, or somebody working in a sector ripe for automation.
Second are the circumstances that are impossible to foresee – for example, having triplets, or discovering a pre-Raphaelite masterpiece in their loft.
Third is how the client reacts to uncertainty, which is often a combination of their financial literacy and their psychology. Some people abide uncertainty better than others.
The power of inflation
We can simplify clients’ investments by dividing them into two camps. In one camp we have nominal assets whose value is linked to a notional debenture to be honored – like cash and most bonds. In the other are real assets whose value is linked to the ownership of underlying assets – like property, commodities and, for the most part, equities.
One key difference between both camps is that each responds differently to inflation.
Inflation, or a sustained increase in prices, is a vital consideration when saving for the future. This is because its effects over time are considerable.
Consider this scenario: In January 1971, you are given a bond that pays 10p per day for the rest of your life. At the time, an 800g loaf of bread sold for 10p, so you could be forgiven for thinking your bread expenses are covered for the foreseeable future. However, by January 2021, the same loaf costs 106p. Now your bond does not cover a tenth of the price. This is the power of inflation.
In the long term, it would have been better to receive a basket of stocks back in 1971, rather than the bond.
Though the value of the stocks – and their dividend payments – would have fluctuated in the intervening 50 years, their values correspond more closely with the inflation-adjusted cost of life (the FTSE 100 launched on 3 January 1984 with a start value of 1,000 – these days its value hovers around 7,000, not accounting for dividends paid in the interim).
This is because the companies behind equities produce the goods and services people pay for, and prices of those goods and services compose inflation.
The Embark Horizon Multi-Asset funds are designed to seek out longer-term gains, while offering five levels of risk to cater for a diverse range of risk attitudes.
Inflation normally occurs for two reasons.
One is scarcity: in times of economic booms, companies can struggle to find workers and resources to cope with demand, wind up paying more to obtain them, and then attempt to pass on these increased costs by raising prices.
The second is currency debasement – a tactic as old as money itself. When governments print more money, the value of the money its citizens have been saving falls.
Here, in one of our favourite graphics, you can see how the silver content of a Roman denarius fell as the rulers of the Empire debased the coins to fund expansion. Evidently, a denarius bought far less in AD268 than it did in AD64.
Source: Tulane University, Société Générale
Whereas modern methods of injecting money into an economy – such as quantitative easing – have more nuance than those used by the Romans, they too can lead to inflation if the increase in monetary mass finds its way into the economy.
When considering ultra long terms, it pays to consider riskier asset classes, if the expected long-term return is appropriate to the risk taken. This is because the effects of compounding at a higher rate will help to meet the higher costs of living brought on by inflation.
Sticking to low-risk, low-return assets – such as fixed income – is unlikely to be sufficient to meet those future expenses.
Though the investment industry tries to frame lower-risk products in a positive light – by giving them names such as ‘conservative’ or ‘cautious’ (as opposed to ‘aggressive’ or ‘adventurous’) – over very long time horizons the ‘conservative’ products are more likely to risk producing a poor return in real terms than the so-called ‘aggressive’ products.
It is for this reason that even those Horizon funds at the lower end of the risk spectrum tend to have a notable allocation to equities. While these funds target a lower expected volatility in the long term, the manager takes two important factors into account: the need for the pot to ultimately meet an investor’s needs, and the fact that as an investment horizon increases, the projected volatility of expected annualised returns across the asset classes decreases.
There are of course three important footnotes to this, which underline the importance of advisers regularly reviewing their clients’ needs.
Firstly, some clients – taking freelancers as an example again – receive an income that is less predictable, so may be attracted to asset classes with more predictable short-term returns. This rainy-day allocation may help them avoid the risk of crystallising riskier assets at an inconvenient time.
Secondly, as clients approach retirement, they may have shorter-term liabilities –in the immediate five years after retirement, for example – as well as longer-term liabilities, and their asset mix should reflect that.
Finally, people may prefer less volatile asset combinations because of their financial personality.
Then there are the benefits of diversification.
Mixing assets has the advantage of reducing risk to a greater degree than its reduction in return. This is because asset classes are not perfectly correlated and react differently to various market conditions. In risk-on scenarios, some investors sell bonds to buy equities (and vice versa in risk-off scenarios). However, by not sitting exclusively in one or the other asset class, investors can smooth their return stream and receive a diversification benefit. A diversified portfolio can therefore give more expected return per unit of expected risk.
This is why diversification is at the core of how the Horizon multi-asset funds are assembled.
An important factor is that expected returns, volatilities, and correlations of returns vary with time – two asset classes have different volatilities and correlations over the long- and short-term.
For example, a 20-year risk-free zero-coupon bond provides an investment outcome which has zero volatility at the end of its 20-year term – so its correlation with any risk asset is zero. However, at different points during those two decades, as its price fluctuates alongside market bond yields, there may be correlation on at least some occasions.
Saving is an asset-liability puzzle. A client’s portfolio should reflect life’s uncertainties and how able they are to endure certain levels of risk.
Long-term saving requires long-term thinking, and that implies factoring in the real value of the final pot as well as the nominal value, and the risk that by being too conservative there may not be enough money for a client’s wished standard of living due to inflation. Investments based on real assets (equities, commodities, property) tend to be more volatile in the long term than those based on nominal assets (cash, government bonds), but also provide a better hedge against inflation.
In this context, education is essential: clients should be aware that (i) the future will arrive, (ii) they will need money in that future and (iii) putting it under the mattress or in low-risk assets will not necessarily help achieve that objective.
Finally, diversification is a powerful tool to reduce expected risk in a way where less expected return is sacrificed in the trade-off, improving the expected remuneration per unit of risk.
Thomas Rostron is Chief Executive Officer of Horizon by Embark