Luke Hyde-Smith: how to invest for inflation

Merryn talks to Luke Hyde-Smith of Waverton Investment Management about the current state of the markets, and how to invest into the kind of inflationary environment we have now.

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Transcript

Merryn Somerset Webb: Hello and welcome to the MoneyWeek magazine podcast. I am Merryn Somerset Webb, editor-in-chief of the magazine. This podcast is being recorded on 22nd February, 2022. With me today I have a new guest – exciting times, someone we have not had before. It is Luke Hyde-Smith, who is co-head of multi-asset strategies at Waverton Investment Management.

I think a lot of you know Waverton. We have interviewed people from there before and had them in the magazine in the past. So, it’s not a new business to us but a new person. Welcome, Luke. Thank you for joining us today.

Luke Hyde-Smith: Thank you very much, Merryn. Delighted to be here.

Merryn:  Now, we are going to talk, I’m guessing, a lot about the market in general, a lot about inflation, a lot about how one should invest into that kind of environment, but let’s start by looking at what’s going on in the market this week. It is all over the place.

Luke: That is absolutely right. We have a very, very tricky market backdrop currently. Clearly, all eyes are focusing on the geopolitical events and what Vladimir Putin does next. We have had news overnight that he had recognised, shall we say, the independence of certain states within Ukraine.

It’s not for me to offer any short-term insight here into the events of the next few days. Suffice to say, we very much hope that the worse will be averted, but I do think this does play into some of the wider fears that are in the market about rates of inflation, how transitory or not they should be, and it quite definitely results on more concerns on energy prices which have been a feature of the market environment for the last few months and have risen dramatically.

Merryn: Do you think they will keep rising? One of things that we heard endlessly is that we shouldn’t worry about inflation because it was just transitory. It would be gone in a couple of months. Gone by Christmas, gone by January, gone by April, gone by this summer, etc. It’s not going anywhere, it doesn’t look like it. Are you firmly out of the transitory camp now and into the inflation is the new deflation camp?

Luke: Well, we think it’s a little more finely balanced than that. I think it is definitely interesting to note that there’s a disinflationary mindset which has really been a backdrop of markets since the GFC.

It’s going to be a hard psyche and narrative to dislodge but it’s quite clear that from an initial supply chain issue due to Covid and the resultant supply/demand mismatch, the supply chain issues, that’s then been followed through with quite a severe energy crunch and rise in natural gas and oil prices. I suppose if we were to see from here a substantial and sustained rise in wages, you then have quite a significant three cohorts resulting in potentially a more challenged inflationary backdrop.

Our base case is we do expect that very high levels of headline inflation to subside somewhat over the next 12 months but it may well be we’re in a regime that is higher inflationary or maybe more volatility, more changes in the inflation rate as we look out from here.

So, it is something that is really the most important macro variable to try and have a handle on but, quite clearly, geopolitical events are difficult to forecast in terms of their magnitude and implication.

But, I would just note we have had this exceptional rise in oil prices and in order for, certainly, the energy component of the inflation numbers to rise at the same magnitude we have seen over the next 12 months, clearly we need the same level, if not more, percentage increase in energy prices which we think is probably unlikely and we see the headline inflation maybe peaking in the next two or three months and coming down as we go further through the course of 2022.

Merryn: So, you’d expect to see the supply chain problems ease. That should be a given, although given China’s zero Covid policy, etc, you might think that supply issues might last longer than one might have thought six months ago with rolling factory shutdowns, etc.

Luke: Exactly. I think it does appear that the worst of the Covid pandemic, in terms of its impact on the global economy, is behind us but you’re absolutely right. The zero Covid policy in China is resulting in perhaps the supply chain issues being longer than people originally envisaged.

Merryn: Let’s say the energy prices flatten out from here. So, let’s assume energy prices flatten. I'm not sure we can assume that but let’s assume that for now. We’ll come back to it. And let’s assume that supply chain issues flatten themselves out. Then, the main risk, the main risk that could drive inflation is rising wages.

Luke: That’s true.

Merryn: Now, so far, in most places we’ve seen wages rising a bit in nominal terms but you haven’t really seen, particularly in the US, people getting real wage rises, although in fact I think in December the numbers did show a slight real wage rise.

When I look at it I think, well, back in the days when inflation was 1%-2%, people weren’t really very interested in inflation, they weren’t very bothered by it, so they weren’t understanding that if they didn’t get a rise they were maybe losing a tiny bit of purchasing power because it was tiny.

But, there’s a very different mindset developing now. People get 6%-7% inflation and they can really feel what it is doing to them. So, labour is beginning to kick up about that.

So, we might see the return of some kind of union power or social media group power of some kind that could very easily drive wages up very significantly, and quite rightly, by the way, quite rightly, just to be clear.

Luke: Having higher wages is not necessarily a bad thing. Does it lead to an inflation spiral, is the question, which gets out of control? And I suppose the way we see the current high levels of inflation and potential wage increases, certainly in nominal terms, there’s a question whether they’re going to increase in real terms, is exactly as you say.

This is maybe five, even ten years’ worth of pretty muted price changes coming through in one fell swoop. So, I see it, we see it as perhaps one period of time where we have a step change followed by a period where it’s a little bit more stable.

And we’re going through, I would argue, peak inflationary concerns currently which are, as I said, being accentuated by the energy issues which are impacted by the geopolitical events in Russia, etc.

Merryn: I wonder if everyone is a little sanguine about this stuff and that once people notice inflation, their attitude towards it changes. Once you’ve had one year worth of inflation rising at 7% and your purchasing power falling by maybe 5% if you got a 2% pay rise, for example, which a lot of people will have this year, a 2% pay rise.

They can see inflation at 7%. They can feel the difference. So, even if we go into next year with much lower inflation, you have a totally new level of alertness among the working population and that does make a difference.

Luke: It undoubtedly does and I think, as I said, it’s not necessarily a bad thing and I think it’s possible that we have a step change in the pricing of many, be it wages, be it goods, be it services, which hasn’t actually occurred for a number of years.

Now, there is an element here. You’ve got to separate what is the cyclical impact v the structural. Some of the big structural forces which impact the inflationary rate have not disappeared. High levels of debt have proven over time to be quite disinflationary. The demographics, generally in older population, tends to be disinflationary.

Merryn: Oh, interesting. Everybody says that. Yes, carry on.

Luke: But, there is a question. There has been some seminal work produced recently which actually argues completely the opposite. Finally, I would just say on the deflationary side technology disruption tends to be disinflationary.

I think those forces have not disappeared but what we may well be into is a slightly more short-term cyclical environment. Rising wages, which haven’t happened for some time. Clearly, energy prices have risen dramatically and the supply chain issue continues to result in some sort of supply bottleneck.

So, cyclically, yes, higher inflationary. I would just call into question do we think inflation is going to run at a 7% compound annual rate from now on for the next five years? A question in our mind.

Merryn: Maybe four or five but, listen, we’ve got to go back to demographics briefly because this is turning into a bugbear of mine. Everybody says to me ageing population, deflationary. And you look at it and say, what are basing that on?

We have no experience of ageing populations except for in Japan. We do have experience of ageing populations but not of populations with that level of demographic change. And we look at Japan and we go, oh, well, there’s been deflation there for decades.

There’s been deflation everywhere for decades and we look at Japan and we think, well, this is unique situation but it isn’t necessarily so. They’ve just been seeing the effects of a global disinflationary environment.

When, I look at ageing populations I think, well, hang on a tick here. We’ve got piles of old people, not very many young people. Old people are extremely demanding. Young people have to do everything for them. If you want to see wages going up very, very fast look at an ageing population environment. Surely, it’s inflationary, not deflationary.

And we say old people, they don’t consume much, they don’t take much. This is old style old people. A lot of old people, they consume like there is no tomorrow. They’re not sitting around like the post-war generation using one toaster for 50 years. It’s a totally different generation.

Luke: Perhaps we will look back and say, actually, the research done on the demographics was incorrect and I think there’s plenty of economic principles which we’ve been calling into question.

One of the things that was interesting pre-Covid was this breakdown in relationship between the Phillips curve, so unemployment v wages. Unemployment was quite low pre-Covid but actually with very, very little pressure on wages.

And maybe the psychological or societal changes that we have seen due to the impact of the pandemic mean that potentially demographics don’t become a disinflationary force.

In reality, though, I think one of the things that perhaps one should highlight is that generally those younger and going through their working age tend to be certainly more productive and spend more and that, in itself, because there are less, is a slightly less of an inflationary force but I guess the jury is out currently out on that and we could potentially argue that for the rest of this podcast.

Merryn: Let’s come back in a decade and finish this one off, okay?

Luke: Yes, do. I’ll be there.

Merryn: For now, let’s work on the basis that the oil price doesn’t double, although I think it might and let’s work on the basis that inflation for the next, let’s say, three or fours years is going to run at something like 4%. Is that fair?

Luke: Agreed. Let’s take that as a base case.

Merryn: Let’s take that as a base. Okay, what does that do to the bond market?

Luke: The other question I’d put back to you then, it depends on how much that is manipulated by central banks but let’s just deal with what the potential impacts of that are.

I think this is quite a profound difference to where we have been historically when inflation rates were running higher, is that we are entering a market environment where historical returns from the fixed income market have been pretty exceptional.

Last 30-40 years you’ve had a circa 8% compound growth rate from your ten-year gilt or lending money to the UK government with a pretty low level of volatility and that squeezed yields down to a very, very low level.

Now, over the last couple of months we’ve seen a pretty dramatic rise of expectations of interest rate rises and what that means for yields on various maturities of government bonds.

But, I think it’s safe to say that it’s very unlikely that we’re going to see those level of returns again. Falling yields from circa tenish through to under one is a very, very powerful tailwind to investors in the fixed income market.

Now, where we are now, with yields just over one and towards 2% for ten-year in the US, those are still low levels and in your environment that you’ve just described where inflation is running at four, a negative 2% real yield on many instruments in the fixed income market, which looks pretty unattractive. So, you can paint quite a bleak picture for the future prospective return even if yields stay static for fixed income investors, a negative 2%.

Now, if the bond market actually reacts to this persistent high inflation and says the only way this is going to be quashed is through higher interest rates and thus resulting in potentially higher yields on fixed income securities. There will be pressure on the capital value as interest rates rise. So, it’s a tough environment for fixed income investors but they have a very good run over the last 30 or 40 year, as I’ve said.

Merryn: But, then there’s a problem here, isn’t there, which is that lots of people hold bonds in their portfolios for safety and to balance out the risks in their equities and, of course, there’s an extra problem in that lots of savings in the UK are in lifestyling funds and these funds shift them gradually into long-dated bonds as they reach retirement age. So, if you’re coming up for retirement age now, you’ve probably lost 10% in the last couple months.

Luke: This is a problem. This is undoubtedly a problem. Now, we are not in the camp to say that one should have zero fixed income. I think it has been proven, certainly when markets are extremely volatile, investors do tend to retreat to the safety, certainly of the US treasury market, but I think it is essential for people to think about what other assets they can bring into portfolios to help mitigate a pretty anaemic return outlook or, indeed, even worse than that, a very bleak return outlook for certain parts of their portfolio.

The point you raise is really important because historically, and certainly from a risk standpoint, many of these assets are deemed as the low risk aspect of portfolios. I think one of the things that’s really interesting about the market dynamic is there is a non-stop siren call about how expensive equity markets have got to and I think it’s fair to say that a lot or some parts of the technology market have reached or certainly had reached quite high valuations.

But, I think that needs to be taken into account, that large parts of the fixed income market look exceptionally expensive and we’ve had a bit of a repricing of that over the course of this year so far.

Merryn: I’ve got yet another new workplace pension. Only yesterday, I got a letter from them telling me about how I was going to be lifestyled as I aged. A long form to fill in to try and avoid being forced into a pile of bonds that I don’t want. But, most people won’t read those letters carefully enough to understand the risk there.

So, here we are with our 40/60 portfolios that we’ve had forever where we believe that we’re going to be safe because we’ve got 60% in equities and 40% in bonds. Our conversation makes it clear that’s not necessarily safe. How on earth do we balance out that risk of our equity portfolios if we can’t use bonds to do it?

Luke: I think that’s a really, really important question and something that we grapple with here, at Waverton. As I said, there is an element and there is a place for some parts of the fixed income market. We do think there’s some interesting opportunities in credit and we do think certain parts of the fixed income landscape, be it index-linked bonds or long-duration treasuries, do have a role to play.

But, in our mind, what you have to try and separate out is the return aspect that one has had from, say, the government bond market v the diversification properties. If you think about those as two different return and risk drivers for portfolios, we’ve initially just focused on what can we add into portfolios that provide some element of that return, a higher, yield, some element of inflation protection?

I think that universe has grown quite meaningfully and encapsulates assets, infrastructure, be that more traditional social infrastructure or more economic infrastructure within the energy…

Merryn: Sorry, how are you defining social infrastructure?

Luke: Social would be schools and hospitals and parts of the very, very limited economic sensitivity but assets which are broadly the backbone to many economies. Hospitals would be a prime example. They’re assets which can be built to serve a wider economic purpose but have limited economic sensitivity but can be quite attractive from a cashflow perspective long-term. So, I think that opportunity set is important for investors to think about.

Now, it’s not a free lunch. There is some element of economic cyclicality or a correlation with some of these assets, be it property or be it other parts of the real asset universe. But, can they help mitigate a poor return outlook for many parts of the fixed income market? Undoubtedly, in our mind.

Merryn: Can you be more specific about where people should invest now, where they should try and mitigate this?

Luke: Yes. From our standpoint, we think it’s interesting to note. I know yourself and your readers look at and read about the investment company sector in the UK and have good knowledge of that universe. I think it’s really interesting to note how that has evolved over the last 20 years.

If you go back to ’99, there was precious little asset diversification you could get from investment companies. There was either equity or private equity and if you fast-forward to where you are today, equities and private equity are still a large part, just over 50%, but there are some really interesting alternative or real asset-type opportunities, be it in infrastructure or specialist lending or renewable infrastructure or other alternative asset classes such as shipping or music royalties, etc.

So, we think there is actually a very effective way for individual investors, professional investors such as ourselves to access some very attractive underlying return streams in a listed manner.

These assets, historically, have been the domain of big, institutional sovereign wealth funds who can manage the illiquidity and, indeed, the scale that you need to access these opportunities.

But, this whole evolution of the investment company sector has provided a really rich opportunity set for us to be able to access, and I hope and I think, investors to be able to protect portfolios against poor returns from fixed income. Where do you go for yield? And, indeed, some of these assets have some pretty attractive underlying inflation-linked characteristics. So, I think that, in itself, is a pretty attractive opportunity set.

Merryn: So, you’re launching this Real Assets Fund, is what we’re getting to.

Luke: Yes.

Merryn: It’s got all these things in it.

Luke: We have launched our Real Assets Fund three-and-a-bit years ago. It is a strategy which targets CPI+4%. It’s got between 40 and 50 underlying investments in. We think it looks really well-placed in the current market environment. It’s got a yield of circa 4%. I think one of the things that I would highlight about it is that on an underlying level nearly 75% of the exposure has some element of inflation protection to it.

Merryn: What’s the top holding in that fund, Luke?

Luke: There’s a couple of top holdings. We own Tritax Big Box, which is a UK Reit or property company which invests in a portfolio of purpose-built logistic hubs around the UK, which is benefitting from the move to e-commerce.

We also own 3i Infrastructure, which is in our mind one of the best and well-managed infrastructure companies in the UK, which provides access to a quite concentrated portfolio of specific infrastructure assets, be it in the digital space or other economic assets. So, we’re quite enthused about the outlook for many of these companies and the individual names that we own in the fund.

Merryn: And you are launching a new fund, right?

Luke: Yes. So, to carry on and as we’ve been running Real Assets for 3.5 years and we’ve had good experience at our firm of running alternatives successfully, one of the areas that we haven’t been able to access directly is the private market opportunity set, direct access to unquoted businesses.

Now, this is an area that has grown phenomenally over the last 20 years. The investment universe has grown by something like 15% compound and I think it’s fair to say, much like areas of the public equity market, there are areas which look expensive and richly valued.

Merryn: A lot of the trusts and funds that have been very vocal about being in the private market have had a horrible couple of months, horrible.

Luke:  I totally agree and I think there’s definitely grounds for caution but underneath the big, old bracket private equity, primarily tech-orientated exposure, there is a growing universe of opportunities in either direct lending, private credit, or some parts of the real asset space which may be smaller and more niche in nature.

We are in the process of launching an investment company to take advantage of those opportunities and, importantly, be a vehicle that can express the very best long-term views of our 25-strong team at Waverton.

I think there are some quite big challenges out there with how one provides capital to business in the most sustainable, long-term fashion in order for them to succeed. There is no doubt that businesses are staying private longer.

That is resulting in a lot of their growth potential staying in the private market space and I think, again, somewhat like the inflationary picture, you’ve got to separate out the cyclical from the structural.

There is some element of overheating in parts of the private equity universe but do we think that universe will grow over the next ten years? We think it will and I think it’s important for us to offer our clients access to opportunities that come our way and allow us to help enhance long-term returns.

The whole point of this here is to have a vehicle, and we’re going to call it The Endowment Fund Limited. It’s going to be a London-listed investment company, following what we believe the very best long-term investors do such as endowments, investing across public and private markets and really harnessing what the best of Waverton do which is direct, it’s global.

And we will be offering clients access to the pipeline that we’ve built, both on the quoted side but importantly in private markets, as well. We’re excited about the opportunity.

Merryn: I bet. You could argue that in the private markets, as well, it’s been the same areas that have become overvalued, tech stocks of all types, anything that can be described as taking advantage of digitalisation or whatever.

In the same way, in the private market, stuff that is cheaper is the stuff has been less popular over the last however long and we’ve wondering in the magazine for some time who is going to eventually set up an investment company of some kind to buy on the private market all the fossil fuel assets that nobody else wants, for example. Might this be that trust?

Luke: This may well be that trust. I don’t think we’re going to have such a narrow focus but I think that gets us on to one of the topics of the day which is all things ESG and sustainable and one of the things that we want to highlight at Waverton is we are not a business that is taking a negative screening approach and say we will not invest in certain industries.

In fact, I think it’s highly likely and one of the themes running through both real assets and, to a certain extent, The Endowment Fund is that the energy transition is likely to be more costly and take longer than many investors and, indeed, people appreciate and, within that, the commodity markets, indeed natural resources, have a vital role to play.

I would be delighted to share with you and readers a fascinating chart, which you’ve seen recently, just how important certain natural resources are to meeting net zero, be it copper, EV, etc.

Merryn: Absolutely.

Luke: And, you combine that, by the way, with the sort of blanket non-investing institutional mindset that we can’t own these companies results in quite a big valuation opportunity and you’re seeing a bit of that this year, where commodity markets, both in the equity side, natural resource equities and, indeed, the spot markets themselves have been very, very strong in an environment which has been quite choppy from a headline level.

Merryn: Yes. I think all readers will recognise with me the endless fun that you can have by explaining to teenagers that pretty much everything around them is made, one way or another, out of fossil fuels.

Luke: Well, exactly. We are not escaping that fact and I think many of the opportunities that one looks at in the real assets space or some of them on the endowment side are exploiting that and I think it’s an interesting dynamic in the current market.

The amazing stat, it was a research house said out of the 400 clients that they were previously or currently broking to, I think only one of them was still able to directly buy fossil fuel businesses. That’s the level of sort of institutional pull-back you’ve seen from these markets and I think that, in itself, provides an opportunity.

If you then think about, well, which assets perform well in a higher and more sustained inflationary environment well, clearly, natural resources have been historically a place that you’ve wanted to have exposure to.

Merryn: Luke, thank you so much. We got through an awful lot there in our 25 minutes. I hugely appreciate it.

Luke: Well, that’s been absolutely brilliant, Merryn. Thank you very much for having me on. I look forward to our chat in ten years’ time about the demographics.

Merryn: Yes. I bet I win that one. I’m certain on this, absolutely certain on this. I’m going to have to keep working for another ten years just so I can make it clear to everybody that I won demographic.

Luke: Right. I’ll see you then.

Merryn: Now, Luke, what website can readers go to you if they want to hear more from you or are you or are you on social media?

Luke: There’s obviously the Waverton website and on the investment company theendowmentfund.co.uk is up and running, so we look forward to keeping people updated with our progress with the upcoming listing.

Merryn: Brilliant and thank you. Anyone who wants more from MoneyWeek, you know where we are, moneyweek.com, where you can sign up for our brilliant daily newsletter, normally written by John Stepek, Money Morning.

You can follow us on Twitter @MoneyWeek. You can follow me @MerrynSW, and you can follow John @John_Stepek, and I think it’s much the same on Instagram should you want to look at pictures of our covers.

Thank you very much for joining us today and if you would like to review the podcast, which we really hope you will but only positively, of course, because that’s how we keep getting the good guests on, please do so at your podcast provider of choice. Thank you very much and thank you, Luke.

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