Inflation is biting. I’ve been sceptical that this was a wage-driven phenomenon, pointing out in early December that UK private-sector employers expected to raise wages lower than inflation, while most public sector employees would struggle to get that.
Chart 1: UK Consumer Price Inflation (%)
Source: Refinitiv Lipper
As millions in the UK struggle with crippling cost-of-living increases, it’s something I’d much rather have been wrong on, whatever the governor of the Bank of England believes. While we’re certainly not seeing the wage-push inflation that was feared last year, neither is it simply down to increased energy costs. As Fathom Consulting shows, it is likely that a reduction in aggregate supply has also played a part, with output struggling to meet pre-pandemic levels (Chart 2).
While it’s unclear as to how embedded inflation is—to what degree it’s a result of shorter-term supply constraints—it’s instructive to look at the current trajectory, and how investors are positioned for its effects.
Chart 2: UK GDP
Source: Refinitiv DataStream/Fathom Consulting
There has been a significant shift in the inflation and rate landscape over the past year or so. At the tail end of 2020, UK CPI had troughed and, although inflation expectations were increasing and the tiger’s tail tugged, the beast itself had yet to stir. That was then, but the above graph tells a different story, with inflation heading upward sharply from March 2021.
The Bank of England responded by raising the base rate from its historic low of 0.10% to 0.25% (16 December 2021) and then to 0.5% (3 February 2022), with some members of the Monetary Policy Committee favouring an increase to 0.75%.
How have UK investors responded over this past year, where inflation expectations have translated into spiking inflation and what looks like the beginning of the rate cycle?
Investors Surprisingly Bullish on Bonds
Let’s look first at bonds. The yield on the benchmark 10-year gilt in early February was at its highest since November 2018 and is trending higher. Its price has slumped. One result of such movements is that the global pool of negative yielding debt fell by 20% in one day, to the lowest amount since October 2018, according to reports.
In the context of rising rates—and the anticipation of this over the preceding months—you would also expect bond investors to respond by reducing portfolio duration, with reallocations from long- to short-term bonds. However, allocations to bonds have increased more than to any other asset class. This is not what you’d expect from an inflation trade.
Bond funds saw more inflows over 2021 than any other asset class, taking in £13.6bn (broadly in line with what they netted in 2020) and have been positive for each quarter of the past year (Chart 3). Net equity inflows were modest in contrast, at £1.8bn, compared with £26.7bn in 2020—about 7% of that of the previous year’s. Indeed, equity funds saw outflows of £4.4bn over the final quarter, with money market funds taking £18.9bn as investors become increasingly risk averse in an uncertain macro environment.
Chart 3: Asset Class Flows by Quarter, 2021 (£bn)
Source: Refinitiv Lipper
The large allocations to bonds may seem surprising at a time when we’re in an inflationary environment, with rates likely to go just one way, especially as most bond fund classifications have posted negative returns over the year (notable exceptions being inflation-linked bonds). Bond investors will likely make losses until rates stabilise.
This likelihood is reinforced by the fact that the bulk of bond flows aren’t going to funds that are best positioned to protect their investors from rising rates (although there has been a £904m increased allocation to UK linkers): of the top-10 money taking bond share classes, accounting for £28bn of inflows, only one was that of an index-linked fund. The rest are general government and investment-grade corporate vehicles.
The bulk of flows are going to passive products, with all but £553m fixed income funds’ £13.4bn over the year going to trackers. Whatever you may think of the pros and cons of the active-versus-passive debate, active managers can manage duration, shortening it in anticipation of rising rates and therefore cushioning portfolios from the effects of rising rates. Trackers won’t.
Re-balancing
So why are bond flows strongly positive? One possible explanation is that, as equities have risen over the year and bonds lost money, large institutional investors have been forced to sell equities and buy bonds in order to stay within their asset allocation boundaries. The pressure to keep buying will be maintained if rates keep rising, but the other main variable, of course, will be what happens to equities, which are already richly valued.
Which leads us to equities… and the rest. Equity sectors vulnerable to higher inflation include growth areas such as technology and consumer staples, where thin margins are eroded by higher costs. On the other hand, financials and energy that can pass costs onto customers can benefit from higher inflation.
Taking a granular look at some classifications that are inflation sensitive in the table below (positive, green; negative, red), no clear story emerges. In general, the sums aren’t large—other than UK direct property, where there have been significant outflows for reasons unrelated to inflation concerns, nothing is more than £1bn.
Table 1: Flows to Lipper Global Classifications Sensitive to Inflation over 2021 (£bn)
Source: Refinitiv Lipper
It does appear, therefore, that over the course of the year, investor portfolios’ exposure to inflation risk has increased. If that is indeed true, and inflation persists over this year, then the average portfolio will likely struggle to perform.
This article was originally published in Investment Week
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