When it comes to monetary policy, asset allocators often accuse the central banks of being behind the curve in terms of tackling inflation. However, one manager who has first-hand experience is Steven Hay, head of income research at Baillie Gifford and manager of the Multi Asset Income Fund.
Before joining the Edinburgh-based asset manager in 2004, Hay worked at the Bank of England for seven years, providing research to the Monetary Policy Committee. As a result, he says he can expel the myth that central bankers know a lot more about what is going on than others.
“They don’t have any magical advantage and this has really helped me think about the inflation quandary going forward,” he says. “My background has given me an ability to imagine myself in their position and the trade-offs that will be ahead, and this has probably influenced my view that inflation remains a significant risk to returns.”
When the Baillie Gifford Multi Asset Income Fund launched in August 2018, Hay notes dealing with inflation was already a challenge, but he says that task has become much harder today. “We have had the view for a number of years that inflation is going to be higher than people expected and, as a result, we have been moving the portfolio in that time to protect against this,” he says.
To achieve this the portfolio has had a reduced allocation to fixed income over the past two years. It has also hedged more than half of the duration risk in fixed income and has upped its weighting to real assets, namely infrastructure and property.
“For anyone relying on a fixed income, one or two years of higher inflation is a bit painful, but a prolonged spell can profoundly dent their purchasing power,” Hay says. “For a long-term income to be sustainable, it needs to be inflation-proof as we believe the risk of a prolonged period of higher inflation is now much higher than at any point in over 30 years.”
So how is Hay addressing this within the portfolio, and does he believe the traditional 60/40 strategy of holding a combination of equities and bonds is a model that should be consigned to the past?
The ‘sweet spot’
Aiming to grow income and capital at least in line with inflation, Hay says he is constantly trying to balance the need for high income today with investments that might not be the highest yielders right now but have the potential to deliver growing income over time.
“Although we invest for income, like all Baillie Gifford funds, we do so from a growth perspective,” he says. “At 3.5% we might not be the highest-yielding fund out there, but we believe that income builds over time, so what we try to do is pick the right companies and stick with them.”
Hay has nine asset classes to choose from within his asset allocation. He aims to combine these to ensure that not only is there an attractive level of income but also enough growth in the portfolio to keep up with inflation.
“We call this the asset class conundrum,” he says. “Within this strategy we did a lot of risk modelling to assess what the optimal mix of all these different asset classes would be to provide us a ‘sweet spot’ to maintain income and capital in real terms.”
Rather than the old 60/40 approach, Hay says the team settled on splitting the strategy roughly into one-third equities, one-third fixed income and one-third real assets, which includes investments in infrastructure and property. Here, Hay says cashflows are often directly or indirectly linked to inflation.
“We face a very uncertain macro environment and you need to have all the tools in your portfolio to deal with a lot more variability and outcomes than we have seen in the past two decades,” he says.
“The 60/40 model was perfect for a period of falling interest rates, but conditions in which rates are rising provides much more of a challenge to fixed income.”
For each of the asset classes held in the Baillie Gifford Multi Asset Income Fund, Hay invests in bespoke income-oriented portfolios that are managed by his Baillie Gifford colleagues.
For example, the global equity segment of the fund – which at the end of March accounted for 34% of the portfolio – is managed by James Dow, while Lesley Dunn runs the high-yield and investment-grade credit portfolios. In total there are seven managers the fund calls upon, with Hay stressing that diversification is key.
“To ensure a resilience of income we need diversification across all the asset classes, globally,” he says. “Since the pandemic broke out in March 2020, it became evident that a huge amount of stimulus was coming into the economy and we believed the supply side would not be able to cope, leading to the view that inflation would be higher and stickier.”
As a result, while still holding high yield credit and emerging market debt, Hay took the decision to reduce the fixed income weighting in the fund, selling almost completely out of investment-grade credit and developed market government bonds.
“High yield bonds are relatively more attractive because their shorter terms make them far less sensitive to inflation, but also because inflation erodes the real value of debt, which is especially helpful to companies with lower credit quality,” Hay explains.
In the hunt for inflation-linked bonds, Hay also found opportunities within emerging markets, which he says is one area within fixed income he can protect the portfolio. “In Brazil, Colombia and Uruguay we have inflation-linked bonds that are generating a positive real yield and providing protection against inflation,” he says.
In total, emerging market debt – with hard and local currency – currently makes up about 14% of the fund’s assets under management, while high yield credit makes up 11.4%. Additionally, using US treasury and gilt futures, Hay notes over half of the duration within the total fixed income pot is hedged.
Turning to real assets – a portion of the fund that has been increasing as fixed income allocations have been falling – Hay says both infrastructure and property are ideal investments in an inflationary world. “While property as an asset class has a mixed record of protecting against inflation, residential property has attractive characteristics,” he says.
“Rental income is supported by employment income. So, if wages are growing, rents can follow.”
With property currently accounting for 7% of the fund’s assets, he says Irish Residential Properties, an Irish residential-focused Reit, is a holding that exemplifies this trend. “It has supportive fundamentals with a strong urbanisation trend and barriers to new supply. These make its income and growth prospects attractive.”
Infrastructure bias
While the property portfolio currently accounts for 7% of assets under management, infrastructure takes up the lion’s share of real assets, with 25% of the fund held in listed assets. Hay says this is partly because of inflation and partly because of the green trade.
“The objective of the fund is to generate a sustainable income over the long term, and this means providing a resilient income in the sustainable economy we are transitioning to,” he says.
For example, Hay says at first glance US-based Ameren and WEC Energy appear to be quite boring utility companies. However, beneath the surface he believes both companies have a strong regulatory tailwind as they help the transition to more renewable energy.
“Normally these businesses are stable and quite boring, but now they have a very supportive regulator and a great growth runway because of the investment that needs go into the energy infrastructure to help us transition,” says Hay. “So, infrastructure is currently an overweight asset class within the fund.”
Another infrastructure holding is HICL Infrastructure, which Hay says has revenue from public-private partnerships that are inflation-linked and from the public sector. “These make it an ideal investment because it is resilient to both the economic cycle and inflation,” he says.
“While we see the risks of higher inflation as material, we don’t have all our eggs in the high inflation basket,” he adds.
“Our portfolio should always enable us to achieve the strategy’s objectives, even if inflation is subdued. It’s just we have more of an eye than most on the risks from higher inflation.”
This article first appeared in the May edition of Portfolio Adviser Magazine
