Latest News 07/06/2021
Cornelian Risk Managed Funds: How are we positioned for inflation?
An update on how the Cornelian Risk Managed Fund Range is positioned in relation to recent inflation concerns.
The threat of inflation has returned to spook investors, with many commentators questioning whether traditional balanced portfolios of equities and bonds can withstand a period of sharply rising prices and higher interest rates. The investment objectives of the Cornelian Risk Managed Fund Range are explicitly linked to growing investors’ capital ahead of UK Retail Price Index (RPI) over the investment cycle, so thinking carefully about how different assets will perform in a variety of economic environments has always been central to our investment approach.
We believe that current conditions require the investment horizon to be split into two very distinct buckets: the post-COVID-19 recovery phase, of which we are hopefully in the foothills; and then the medium-to long-term, where the range of potential trajectories for economic activity, inflation and interest rates is wide. Our job is to put together a portfolio that can capture the potentially explosive short-term post-COVID-19 reflationary pulse, while at the same time has sufficient resilience and diversification to withstand and hopefully thrive in a range of longer-term scenarios.
What does this actually mean in practice? Almost irrespective of whether the current spike in prices caused by COVID-19-induced bottlenecks proves transitory or leads to a genuine sustained pick up in inflation, in most scenarios we believe longer-term interest rates are probably too low. Given that long term risk-free rates drive the majority of asset prices to varying degrees, avoiding those parts of the market where current asset prices require interest rates to stay around record lows, or indeed to fall further to generate acceptable returns, feels sensible.
In fixed income, this means completely avoiding the majority of the developed government bond market until a reasonable term premium is re-established. The circa 7% fall in the gilt market year-to-date is an early warning of the potential pain that awaits vast swathes of the government and high-quality corporate bond markets, where lengthening maturity profiles have seen interest rate sensitivity rise markedly over the past two decades. In contrast, the risk-reward trade-off from financing the real economy on a relatively short term basis at this stage of the economic cycle appears to offer a much more appealing trade-off. While yields from short duration investment grade corporate bonds may be unexciting and credit spreads not the bargain they were in April of last year, the powerful force of being repaid at par within a short timeframe should enable investors to generate a reasonable and predictable yield. This yield should rise over time as maturing bonds are reinvested at higher rates, with limited risk to capital in the absence of an unexpected wave of corporate defaults. Keeping interest rate sensitivity low today creates valuable optionality to shift into longer maturity bonds at higher rates at some point in the future, should an inflation scare cause the yield curve to steepen materially.
In equities, we have shifted emphasis away from defensive growth companies to more cyclical industries, reflecting where we see value today given the positive near-term economic outlook, while also recognising the potential for an unwind of the great re-rating of crowded long duration growth stocks in recent years. One out of favour area of the market that meets our twin criteria of benefitting from the post-COVID-19 recovery while also providing a margin of safety should less favourable economic conditions prevail over the medium to long term is the banking sector. The COVID-19 pandemic provided the first real world stress test of the post-Global Financial Crisis reforms of the financial system, and the banking sector has come through with flying colours. Having withstood a spike in COVID-19-related bad debt provisions, the tailwinds of rising interest rates, robust capital adequacy and collateral values (residential property, cars etc), falling default rates and rising credit demand from consumers and businesses should see profitability and dividends recover strongly in coming years. With valuations remaining undemanding, a long-overdue re-rating could finally be in the post after more than a decade of restructuring and reform.
Despite our caution on areas of the fixed income market, we do not believe that all long duration assets with contractual income are expensive. Many ‘real’ assets with a clear and enduring purpose such as infrastructure projects and property sub-sectors such as supermarkets, medical centres and care homes offer predictable long term, inflation-linked income streams and are still valued at relatively fulsome yields that provide a significant cushion against rising interest rates. The risk profile of these diversifying assets sits somewhere between traditional equity and debt, and the vibrant and expanding investment trust sector of the London Stock Exchange offers investors a wide range of options to gain access to these scarce sources of yield and inflation protection.
© Morningstar 2021. All rights reserved. Use of this content requires expert knowledge. It is to be used by specialist institutions only. The information contained herein: (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied, adapted or distributed, and (3) is not warranted to be accurate, complete or timely. Neither Morningstar nor its current providers are responsible for damages or losses arising from any use of this information, except where such damages or losses cannot be limited or executed by law in your jurisdiction.
Risk Managed Funds Investment Team