Kyle Caldwell explains how fund managers seek to protect and profit from rising levels of inflation, a key risk for 2022.
It appears the central banks either underestimated or have a much longer time frame than most when it comes to defining ‘transitory’ inflation.
In March, inflation stood at just 0.7%, but since April it has been on the rise. In 2022, the cost of living is expected to increase further. Ben Broadbent, deputy governor of the Bank of England, said earlier this month that UK inflation is expected to soar “comfortably” above 5% next spring when energy regulator Ofcom increases its price cap, which will negatively impact millions of households.
UK inflation is at its highest rate in a decade, having risen to 5.1% in November. Across the pond, US inflation rose to 6.8% in the same month, which is its highest level since 1982.
It was expected that inflation would be a temporary phenomenon in response to the global supply chain problems that have materialised since the re-opening of economies following lockdowns. However, inflation has intensified and been sustained for longer than central bankers had been expecting.
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Inflation has been a concern for professional investors, leading many to make adjustments to their portfolios . Below, we run through some of the main tactics that fund managers use.
Targeting shares with pricing power
Companies that possess pricing power have the ability to pass on increase in the cost of living. Earlier this year, in an interview for interactive investor’s Funds Fan podcast, Anthony Cross, fund manager of Liontrust Special Situations, cited Diageo (LSE:DGE) and Unilever (LSE:ULVR) as having “decades of experience in being able to adjust prices in line with inflation”.
Cross also identified engineering companies as having “strong intellectual property” and “pricing power”. A top 10 holding for the fund is Spirax-Sarco Engineering (LSE:SPX).
Laura Foll, co-manager of Lowland Investment Company (LSE:LWI) also suggested engineering firms could protect against the effects of inflation. Speaking to interactive investor as part of our Fund Insider video interview series, Foll named Morgan Advanced Materials (LSE:MGAM) and IMI (LSE:IMI) as two companies that she owns in the sector.
She says that market-leading companies that are really specialist in what they are producing, whether that’s a service or a product, have the ability to pass on price rises.
Foll adds: “The industrial companies that we still have listed in the UK are not widget manufacturers. They are very specialist engineering companies that, in order to survive, have had to become very specialist market leaders in the area they are in. The evidence we have so far suggests these companies are managing to pass on these cost pressures because this small component they are making is absolutely essential [in] very big supply chains.”
Interest rate rises are one of the key tools central banks have to tackle inflation. Last week, the Bank of England made its first move, increasing rates from 0.1% to 0.25%. One or two more small increases in interest rates are expected in 2022. The prospect of interest rates rising from their historic lows is one of the reasons why Foll has been increasing exposure to banks over the past year. The sector benefits from higher interest rates. Foll has been adding to NatWest (LSE:NWG) and Lloyds Banking Group (LSE:LLOY).
The fund manager explained that valuation was not the only factor behind increasing exposure to banks. Speaking ahead of the Bank of England’s interest rate rise last week, she said: “It is also thinking about where they sit within a portfolio. Presumably there will be an interest rate rise at some stage and we have to have a portion of the portfolio that does well in that backdrop.”
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He said in September: “We want more luxury, more premium, more pricing power in the portfolio. This is why we will continue to build the holding in Fever-Tree.
“It is also why Diageo is so important for the fund – currently the second-largest holding, just behind RELX (LSE:REL). With each passing year, more of Diaego’s growth and value is accounted for by its super-premium and premium brands.”
Customer service is a key inflation ingredient
Gervais Williams, the UK small-cap stock specialist and manager of Diverse Income Trust (LSE:DIVI), says that rather than just focusing on pricing power, he views companies that have “outstanding levels of customer service” as the most resilient against rising levels of inflation.
“The key issue isn’t just pricing power, but the ability of companies to hold on to margin, and I think that’s heavily related to customer service. We look at our companies and we ask them very closely, not so much how strong their business is, but how well the business is aligned to looking after customers.”
Williams adds that the retention of staff, and having outstanding levels of customer service, gives a business “something to defend” when its prices to customers are increased in line with inflation.
Among Diverse Income’s top holdings are K3 Capital Group (LSE:K3C) and Strix Group (LSE:KETL). The former is an adviser to small- and medium-sized enterprises, while the latter is a designer, manufacturer and supplier of kettle safety controls.
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For the bond market, inflation erodes the value of the income that bonds pay. As with equities, some types of bond are much more resilient than others in the face of rising prices, for example, short-duration bonds. Such bonds, which have a lifespan of a couple of years, are less sensitive to interest rates than long-duration bonds, which have a lifespan of 20 or 30 years.
Inflation-linked bonds are a way of profiting from rising levels of inflation.
Peter Spiller, fund manager of Capital Gearing (LSE:CGT), has just under a third of the trust's assets in US inflation-linked bonds – known as Treasury Inflation-Protected Securities (TIPS). Spiller expects inflation to elevate in the years to come, which he thinks will be welcomed by central banks as a means of reducing some of the huge government borrowing that has taken place in response to the Covid-19 pandemic.
Speaking to interactive investor as part of our Fund Insider video interview series, Spiller explained: “We are less optimistic about inflation than the market is generally. Although we fully concede that a lot of the current levels of inflation are driven by shortages of one kind or another as economies re-emerge from Covid-19, there is a real danger in our view that the current levels of increase get embedded in wage increases.
“And then after that we are likely to see substantially high inflation, which after all is what central banks have been asking for and hoping for, for quite a long time. I think they are going to get it, but they might get a little more of it than they really want.”
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Spiller, however, does not expect interest rates to return to pre-financial crisis levels anytime soon. He points out that the Bank of England does not have a lot of flexibility to raise interest rates significantly due to high household debt levels.
“They are constrained because debt levels are so high. In the UK, you could not see interest rates at 4%, for instance, without the housing market falling over and causing huge banking problems,” he says.
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