Positioned for higher inflation
My column last month, ‘Preparing for inflation 2.0’ (16 July 2025), revisited the reasons for remaining of the view that consensus forecasts are underestimating the level of inflation going forward, and consequently overestimating the extent and speed of interest rates cuts. The commentary since around the Bank of England’s expected cut was illustrative. Higher and more volatile inflation is here to stay, together with sluggish economic growth in most western economies. Portfolio construction should ensure asset allocation is adjusted accordingly. Perhaps the most important consideration is how diversification can best be achieved going forward, given key assumptions are probably no longer valid.
Equity positioning
Our portfolios are underweight equities relative to their benchmarks for reasons highlighted in previous columns. Periods of high inflation, particularly when allied to sluggish or no economic growth, have not been kind to equities.
Apart from higher inflation, ever higher government borrowing across the western world is a factor. Politicians need to face reality by cutting spending, which is growing faster than their economies can fund – in part because of ageing populations. For example, estimates suggest UK GDP would need to rise by 3% every year in the coming decades to compensate. This will not happen. And taxes cannot keep rising. High government spending crowds out the private sector and, together with high taxes, stifles enterprise and economic growth. This has consequences for equity markets.
Within their equity weighting, our portfolios are underweight the US given concerns about the extent of market concentration fostered by the larger technology companies. Few are disputing these are good companies, but valuations still matter – especially as cashflows are increasingly committed to AI where the extent of profitably is still uncertain. Outside the US, the portfolios are overweight markets which appear to offer better risk-adjusted returns while proffering reasonable levels of income, such as in the UK which so far this year is rewarding investors.
There is also a meaningful exposure to ‘value’ stocks, especially as the journey unfolds – key examples include Temple Bar Investment Trust (TMPL) and Fidelity Special Values (FSV). Historically, periods of high inflation and low growth usually favour such stocks in part because higher interest and discount rates bring into question the often-lofty valuations afforded the future cash flows of growth stocks. The more reliable near-term cashflows and cheaper ratings of value stocks become more attractive. A good example is during the stagflation of the 1970s when growth stocks underperformed meaningfully as valuations contracted. As ever, sector and stock selection are important.
Achieving diversification
While being underweight equities, the challenge in the current environment is to achieve meaningful diversification. As touched upon in last month’s column, history suggests higher inflation and interest rates have tended to result in a more positive correlation between the various alternative asset classes, thus making diversification more challenging. All boats catch a rising tide. The reverse tends to be true in periods of lower inflation. The period of low inflation and rates lasting some decades prior to 2022 favoured the more traditional diversification proxies. Since then, the current economic environment is questioning key assumptions whatever the talk of lower inflation and falling rates.
A good example is bonds – particularly government. Historically, a 60/40 split between equities and mostly government bonds was thought sufficient diversification. Research shows such a split achieved an average annual volatility of c.8% in the decade prior to 2022. While questioning the extent volatility alone represents risk (a discussion perhaps for another day), this combination was deemed fit for purpose. Decades of low inflation and rates embedded the concept. Yet in the years from 2022, the figure has risen to c.13% which is far less effective. Higher inflation rightly brings into doubt the diversification credibility of bonds.
Within the asset class, corporate bonds and private debt are favoured over government debt. Both types of debt, particularly higher-yielding corporate debt, should better cope with higher inflation. However, in general, the portfolios are underweight this asset class.
Given the underweighting of both equities and bonds, alternative assets are employed by the portfolios to achieve their respective objectives and risk profiles. The aim is to increase exposure to a broad spectrum of asset classes which to varying degrees are ‘uncorrelated’ – assets that tend not to move in the same direction as equities, over the same period. Some are more sensitive than others. A further consideration pays tribute to the objective of increasing the income level and yield of the portfolios as the investment journey unfolds – capital preservation trusts, cash, and gold and silver being the exceptions in this regard.
The infrastructure and renewable energy sectors are certainly out of favour as evidenced by their discounts. Portfolio holdings include HICL Infrastructure Company (HICL), International Public Partnerships (INPP), The Renewables Infrastructure Group (TRIG) and Foresight Environmental Infrastructure (FGEN). Such discounts have not escaped notice with M&A activity picking up. Although there has been some recovery in performance lately, the quality of the businesses and management should maintain momentum over time. Meanwhile these holdings are high yielding with all increasing their dividends – the extent their revenues benefit from inflation sometimes being underappreciated by markets.
Other asset classes which offer attractive and sustainable levels of income include specialist lenders and commercial property. Holdings include BioPharma Credit Investments (BPCR), Sequoia Economic Infrastructure (SEQI) and Schroder Real Estate Investment Trust (SREI). Again, attractive businesses and company discounts combined with experienced management teams with good track records and handsome yields suggest optimism going forward – with revenues in some cases again benefitting from higher inflation.
However, the key change in recent years has been the gradual increase in exposure to precious metals and miners as highlighted in previous columns, which has complemented existing exposure to commodities. These are investments which usually perform well during sustained periods of higher inflation – the case being reinforced by geopolitical uncertainty. Holdings include a physical gold ETF given there is no investment trust alternative, CQS Natural Resources Growth & Income (CYN) with its recently introduced 8% of NAV dividend policy, BlackRock World Mining Trust (BRWM), and Golden Prospect Precious Metals (GPM) which also promises one-in-five subscription rights at 48p a share.
It is perhaps worth adding that while diversification is rightly seen as a defensive posture to protect past gains during market setbacks, it can in itself produce good returns. Challenging times present both risks and opportunities. It is perhaps no coincidence that our more conservative portfolios have so far kept pace this year with some of the growth portfolios, during a period of rising volatility in equity markets. While there is no reason to believe the long-term case for correctly positioned equities is still not valid, effective diversification that reflects the current investment landscape should become increasingly valued – and continue to reap rewards.
Disclaimer: The information contained in this article does not constitute investment advice or a personal recommendation and it is not an invitation or inducement to engage in investment activity. You should seek independent financial advice as to the suitability of any investment decision. Past performance is not a guide to future performance. The value of investment company shares, and the income from them, can fall as well as rise. You may not get back the full amount invested and, in some cases, nothing at all.
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