Inflation: How it impacts the Governed Range

Euan Craig 22 April 2022

Euan Craig, Investment Proposition Manager at Royal London, looks at current levels of inflation and how this impacts the different asset classes used in the Governed Range

What is Inflation?

Inflation is something we hear a lot about in the press: we know it makes our everyday purchases more expensive, but it can often be difficult to quantify. With the exception of things like petrol prices, it can be difficult to see how this impacts us in the short term. Do we really notice that the price of a loaf of bread has gone up 5 pence or a pint of milk is 8p more than it was last month? Probably not.

Unleaded fuel bottomed out at just under 107.11p a litre at the height of the pandemic, compared to over 163p a litre at the time of writing. Gone are the days you could put £20 in the car without thinking and it would last a week. How we all wish life was still that simple!

This short-termism may be fine when we’re going about our day-to-day, but it could be risky when it comes to our pension savings. Each business cycle has inflationary periods, and that’s exactly what we’re seeing just now. UK inflation hit 7% in March 2022 which is the highest level in almost 10 years. In the US, it’s even higher at 8.5%. Different types of investments perform in different ways depending on several factors, and inflation is one of these key factors. For example: when inflation is low, equities tend to perform strongly because of increased consumer spending due to lower borrowing costs. However, when inflation is rising, index-linked gilts and commodities come to the fore; particularly commodities as inflation can be driven by increasing oil prices and raw manufacturing materials becoming more expensive.

How do different asset classes react?

This is why it’s so important to have a mix of assets which can help support investments through these periods of inflation. A plain vanilla 60/40 equity/bond fund simply won’t offer the diversification required to support customers’ pots through this, particularly with Gilt yields starting from all-time lows. We believe our approach of combining the eight different asset classes we currently use in the Governed Range can help us manage our customers’ investments through these inflationary periods.

We’ll start with Fixed Income as this is the asset class which has the most difficulties in an inflationary market because as interest rates begin to rise, so do the yields offered on new bonds being released to the market. This makes the existing bonds less attractive to the market meaning they fall in value. There are a number of different ways you can manage against this; the first is to shorten the average duration of your existing bond holdings as yield rises have less of an impact the closer the bond is to redemption. You can also invest in Index-Linked Bonds like we do in our Governed Range; these can reduce the impact of rising yields as both the coupon and yield payments you receive from your bond will rise in line with inflation.

We’ve already touched on Commodities which are a strong hedge against global inflation due to the drivers behind inflation often being the commodities themselves. Much of the recent inflation we’ve observed has come from rising oil and gas prices and the cost of raw materials for activities such as housebuilding and car manufacturing increasing.

Property is another asset which offers a hedge against inflation. Much of the growth in our property fund comes from rental income which averages around 4% per year. This is important as it’s a steady stream of income which, in most conditions, should outpace inflation.

Equities are usually considered the main ‘growth’ asset within a multi-asset portfolio and tend to outperform inflation in the long run, so it’s important to have equities as part of your long-term strategic asset allocation. However, during inflationary periods, some equity markets can struggle. This is particularly true in cyclical sectors such as Industrials and Consumer Discretionary. As inflation increases and central banks inevitably raise interest rates, household bills increase and the cost of borrowing also rises which leads to a reduction in the purchases of non-essentials in order to focus our spending on what we need. This is where defensive sectors such as Healthcare and Consumer Staples come to the fore. A company like Unilever is a prime example here: it doesn’t matter what level inflation is at, people still need to buy staple goods such as toothpaste and shampoo.

This is also where your regional allocation can add further benefit depending on the make-up of each individual market. Global stockmarkets - particularly the US and Far East - have more of a Growth style bias, which effectively means there are more businesses with greater prospect of rapid expansion. These types of companies thrive in a low interest rate environment as the cost of borrowing is low, meaning they can afford to spend more on product development. The value of the company is also calculated based on future growth potential and future turnover potential, which again benefits from low interest rates when calculating future cashflow. This is why we’ve seen Global markets - particularly the US - outperforming other regions over the past 5 years. The UK market is predominantly made up of businesses which have already gone through a period of expansion and are valued based on their current earnings, rather than how much the business could grow in the next 20 years. This is often referred to as ‘value’ investing and this style tends to perform better during periods of inflation. This is because these companies typically rely less on borrowing, meaning the higher interest rates - which make debt servicing more expensive - are less of a concern.

It’s important to have a mix of different regions, styles and sectors within your equity investment and we believe our mix of 35% UK, 55% Global Developed and 10% Emerging Markets allows us the flexibility to meet our customers’ objectives in both inflationary and deflationary markets due to the diversification across different regions and sectors that this approach offers.

Cash is another asset class used in the Governed Range and is a lot easier to understand when it comes to the impact of inflation. Cash will almost never keep pace with inflation which is why it’s classed as a defensive asset, but it’s also an investment type which performs better in inflationary periods due to interest rates we receive from our banks being closely correlated to interest rates set by central banks. As inflation and interest rates rise, so does the interest we receive on our current accounts, and the cash investments we make within the Governed Range are no different.

It’s about more than just inflation

Investing, of course, comes down to much more than just inflation. Global growth, investor sentiment, seasonality and currency models are just a few of the other inputs used to instruct our asset allocation process. RLAM’s multi-asset team who manage the tactical asset allocation of the Governed Range use the Investment Clock to help with their decision making. As you can see below, inflation is just one of the Clock’s inputs and can help ascertain which part of the business cycle we are currently in and which asset class we should favour.

	Growth	Inflation	Bonds	Stocks	Commodities	Cash
Reflation			9.3%	-1.5%	-30.1%	2.7%
Recovery			4.5%	17.9%	-9.3%	1.0%
Overheat			-0.3%	8.9%	17.0%	-0.1%
Stagflation			-0.7%	-13.0%	38.9%	-0.4
	Average return		2.8%	7.2%	1.4%	0.6%

^{Source: RLAM, Analysis from April 1973 to September 2021. Real returns in US dollar terms. Indices used are ML Treasury & Agency Master, S&P Composite, GSCI Commodity index and US 3-month T Bills.}

SAA v TAA

When designing a long-term strategic asset allocation, it’s important to avoid short-termism and focus on the long-term goals of your portfolio. When investing over the long-term, markets will go through periods of high inflation, low inflation, high growth, low growth, bull markets, bear markets, and recession: you name it, the market will experience it. It is very difficult to avoid losses during the more turbulent periods, but a diversified asset allocation should offer more protection than a portfolio which holds fewer asset classes.

Where we can take advantage of the short-term noise is by giving RLAM’s multi-asset team the tools to run their tactical asset allocation strategies which have added significant value to the Governed Range over the past few years. This tactical overlay, coupled with a diversified strategic asset allocation, allows us to flex exposure up and down to each of the asset classes depending on where we are in the economic cycle and where we believe value can be added, whether that be by increasing our exposure to defensive assets during a market downturn, or increasing our exposure to risk assets during strong growth periods.

About the author

Euan Craig is an Investment Proposition Manager at Royal London. He is responsible for the day-to-day management of the Royal London investment proposition which includes responsibilities for oversight, governance and selection of the options available on our fund range. Euan contributes to numerous committees across the Group, both investment and otherwise, and regularly attends external governance meetings of Royal London clients to discuss anything from investment performance and proposition enhancements to the current state of the market. He is also a holder of the Investment Management Certificate.