The durability of real return funds in an inflationary environment

From

Andrew Yap

As the world adjusts to COVID and vaccination rates continue to rise, there’s much hope that life will return to some form of normal in the near to medium term. Consistent with this view, it’s likely that global economies ‘reboot’ supported by an easing in restrictions on movement, a rise in consumption (particularly within service orientated sectors such as tourism), a clearing in bottlenecks across logistic channels, and improved labour market conditions.

Amidst this backdrop, there’s been ongoing rhetoric regarding the prospects of a re-emergence in inflation, and ultimately the impact this may have on the forward prospects for asset classes and at a time where many are trading at rich valuations (relative to historical averages). This matter is further complicated by factors such as unintended outcomes from central authorities unwinding Quantitative Easing (QE) and governments removing fiscal stimulus from the economy.

In past years, we’ve written extensively about the theoretical merit of real return funds (RRfs), noting that their flexible investment mandates provide them with greater optionality (relative to their SAA-counterparts) to adjust asset class exposures in response to changing market conditions. However, little consideration has previously been given to their inflation protection qualities, noting that many have investment objectives linked to the Consumer Price Index (CPI).

Understanding the concept of inflation

At a high level, inflation refers to the movement in the price of goods & services consumed by households. The most well-known indicator of inflation is the Consumer Price Index (CPI). This measure, also known as Headline Inflation, is calculated by the Australian Bureau of Statistics (ABS) and is released to market on a quarterly basis.

Movements in the headline inflation rate can be relatively volatile when assessed from one quarter to another. Cognisant of this, the ABS also release alternative measures of inflation to provide further information on how Australia’s underlying inflation is tracking. The most common amongst these are the Trimmed Mean and Weighted Median measures, albeit an exclusion-based CPI measure is also calculated, one that removes highly volatile categories such as fuel.

While a detailed understanding on the calculation methodology supporting each of these measures is beyond the scope of this article, it’s worth noting that the quarterly movement between these measures can be quite meaningful when assessed from one release to another.

Transitory versus structural inflation

An informed assessment of inflation necessitates more than just a view on its rate of change, but also its persistence. Regarding the latter, economists tend to focus on the trajectory and strength of inflation. Where there’s a short-sharp rise in inflation, this is often referred to as transitory. Conversely, where there’s a sustained upward trend, this is regarded as structural.

Transitory inflation tends to be driven by demand related factors and these dissipate once supply catches up to meet with the imbalances. Conversely, structural inflation is impacted by supply side factors which can include events such as wars, droughts, floods, bottlenecks across supply chains, etc.

Managers of RRf’s spend considerable time attempting to frame Australia’s inflationary backdrop as either transitory or structural, and for the purposes of providing insight into the potential response that the Reserve Bank of Australia (RBA) may take. Historically, the RBA has tightened monetary policy (i.e. increase the official cash rate) where trimmed mean inflation has established a persistent upward trajectory above 2.5% as shown in the chart below. These responses have tended to be linked to the emergence of more sustained as opposed to transitory inflation.

In such an environment, we believe there’s scope for RRfs to produce competitive performance outcomes, notwithstanding the negative impact that structural inflation may have on the performance of asset classes such as bonds. This reflects the following:

  • Time: as pricing pressures tend to be more persistent (rather than episodic), managers have greater time to adjust portfolio positioning, and
  • Imbedded flexibility: relative to their SAA-counterparts, there’s greater opportunity for RRf managers to alter portfolio positioning to benefit from the prevailing macro environment.

The above environment contrasts with one in which there’s a short-sharp spike in inflation (i.e. transitory) where it’s believed that RRfs are more likely to lag their CPI target in the near term. This reflects the lagged nature of the ABS’ quarterly inflation data (i.e. the data for June 2020 was released in late July), which makes it difficult for managers to adjust portfolio positioning in response to stronger than anticipated price movements. Effectively, managers are unable to retrospectively adjust asset class exposures and lean their portfolios toward those market segments that benefit from such price movements. And for those managers adopting headline inflation for benchmarking purposes, the extent of underperformance is likely to be more profound.

Inflation and asset class opportunities

To provide an indication on how various mainstream asset classes may perform where inflation is on the rise, we’ve produced the following table.

The extent to which managers of RRfs implement conviction-based views and alter portfolio exposures in response to a re-emergence of inflation will depend on several factors including their fundamental views, market timing capability and mandate constraints.

We believe that the performance of RRfs will be most heavily influenced by market timing. This will be particularly pertinent in an environment where asset class valuations appear to be stretched and inflationary pressures are building.

An issue however is that few RRf managers have demonstrated an ability to consistently add value through market timing activities. Furthermore, the level of value -add has dissipated since the advent of QE, which has acted to lower market volatility, making it more challenging to implement strategies such as tactical and dynamic asset allocation.

Cognisant of this challenge, there’s been a growing focus by managers on strategy selection and sector structuring. Regarding the latter, this has become particularly evident with respect to fixed interest and equity exposures. In terms of fixed interest, we’ve observed growing exposures to inflation-linked bonds and floating rate credit. In terms of equities, strategies have been focused on value-orientated sectors and those likely to benefit from a re-emergence from inflation (ie. hotels, tourism).

What may the future hold?

Determining how to position a multi-asset portfolio through these unknown market conditions will no doubt be challenging and translate into a broad set of performance outcomes.

If inflation subsequently proves to be more persistent and the RBA was confident inflation was in the upper end of the targeted range, the next course of action would be an unwinding of the RBA’s bond purchasing program (also known as ‘tapering’). Tapering is likely to have an impact on funding rates, most notably across longer-dated maturities (i.e. 10 year rates) which are likely to rise and place pressure on equity valuations and translate to meaningful losses on bond portfolios. This was the experience of the US in the latter part of 2013 when it first announced its intention to taper, which also led to a significant rise in market volatility. Equities managed to perform reasonably well after some initial volatility.

The key conclusion to reach here is that the actions of the RBA and governments will have an impact on funding rates, valuation multiples, market volatility and ultimately the direction of asset classes. As such, investors seeking exposure to RRfs should expect portfolio outcomes to vary meaningfully across the sector.

By Andrew Yap, Head of Multi-Asset and Australian Fixed Income Research

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