Faced with a challenging investment environment, we asked five of GAM Investments’ and our partner firms’ brightest investment minds to share their views on how to protect returns and diversify portfolio risks in a world of surging inflation and rising interest rates.
26 April 2022
Around the world, inflation rates are hitting multi-decade highs and central banks are scrambling to respond. In March, US inflation soared to 8.5%, the highest rate in 40 years while UK inflation climbed to a similarly high 7% and eurozone inflation reached 7.4%. Hit by two years of uncertainty and supply constraints caused by the Covid-19 pandemic, and compounded by the shock of the Ukraine-Russia conflict, the global economy is straining under ever-increasing prices. Against this backdrop, central banks are rapidly altering their global growth outlooks and responding by turning off the monetary taps. The US Federal Reserve increased rates by 25 bps in March and Chair Jerome Powell indicated a 50 bps increase is possible at May’s meeting. Other developed economies, such as the Bank of England, are responding with similar hikes. As a result of runaway inflation, interest rate increases and ongoing geopolitical uncertainties, investors are having to adapt to a vastly different environment to that experienced in the previous decade.
Gregoire Mivelaz - Subordinated Debt
While the prospect of rising rates is quite challenging for bondholders in general, subordinated debt, referring to bonds issued for capital purposes instead of funding purposes, can provide capital preservation via strong credit quality, deliver high and steady income and has lower sensitivity to interest rates. Not all sectors and bonds are equal, subordinated debt is mostly issued in a fixed-to-floater format, providing low sensitivity to interest rates. Additionally, the financial sector issues the majority subordinated debt in Europe, which is the one sector that benefits the most from rising rates. We believe that European credit will outperform US credit, with the European Central Bank (ECB) likely to hike rates fewer times than the Federal Reserve (Fed). As a result of these factors, we believe that subordinated debt is not just complementary to high-yielding strategies but, in the current environment, is part of the solution. Furthermore, in our view, we are at the best entry point for the asset class for the next two to three years.
Adrian Owens - Global Macro and Currency Fixed Income
We believe that central bankers face significant challenges as growth risks have increased in the face of the inflationary environment, and exacerbated by the war in Ukraine. As a result of these growth concerns, we have seen front end rates sell off. In this environment, we believe break-evens are attractive. Secondly, it could be beneficial to be able to short interest rates. Interest rates are heading higher, and we think much higher than investors have currently priced. Therefore, being able to short markets like the US, UK and Europe makes a lot of sense. Another strategy in a world of higher interest rates is to try and position portfolios so that they have limited correlation with more traditional asset classes, such as relative value trades. Going forward, we think inflation protection, positioning for higher rates, and relative value trades makes more sense than ever, when faced with some of the headwinds that we are seeing today.
Tom Mansley - Mortgage-Backed Securities
Mortgage-backed securities and asset-backed securities provide credit exposure which allows investors to earn attractive returns as long as the credit is solid. Mortgages have two lines of defence in order to get money back in this situation. Number one is the borrower and number two is the asset behind the mortgage. In terms of the borrower, unemployment today is below 4% in the US, which means there is a strong jobs market. Furthermore, the proportion of income that goes towards servicing debt, such as mortgages, auto loans and student loans, is at a record low since the Federal Reserve started collecting the data in the early 1980s. As a result, delinquencies and foreclosures are low.
Additionally, house prices have risen significantly, meaning that the asset securing the loan is very solid. We believe prices are well supported going forward as we have a record low inventory of homes available for sale and we have very strong demand for those homes. This means the credit is strong and, as a result, has very little interest rate risk, low volatility, low correlation to other assets, and since spreads today are wider than they were even before the Covid-19 pandemic, we believe we are at an attractive entry point in order to earn a strong return going forward. Inflation will push up wages, and as wages increase, it should become easier to make mortgage payments. Further, inflation bolsters home prices, so the asset is even more secure, making mortgages with credit exposure secure.
John Seo - Catastrophe Bonds and Insurance-Linked Securities
Catastrophe bonds and insurance-linked securities, by their very nature and construct, are adjustable-rate instruments that index well with interest rate rises and inflation. As the coupons are floating rate, every basis point rise in interest rates on the short end of the curve flow directly into the coupon.
Regarding inflation, insurance companies meticulously reset their premiums on an annual basis with every policyholder according to experienced and expected inflation and therefore, the nature of the business itself is indexed to inflation.
A third feature of catastrophe bonds and insurance-linked securities is that an environment filled with fear, uncertainty and doubt drives insurance and reinsurance sales. It is a psychological reaction to the environment that we are in that the demand for insurance and reinsurance increases significantly, and the willingness to pay higher premiums is increased.
Therefore, the benefit of market uncertainty is that it drives insurance premiums higher, but we do not necessarily pay for that with a higher risk because a market crash or even a tragic event, like the war in Ukraine, cannot cause an earthquake or a hurricane to occur.
Paul McNamara - Emerging Market Debt
Emerging markets (EM) are beginning to look interesting now as global growth patterns have begun to shift. Over the last year and a half, EM has underperformed due to slower vaccination rates or continued lockdowns, while the US dollar has remained strong. As we see a pick-up in growth in emerging markets and in Europe, that tends to mean that the strength of the dollar is less of a hurdle to overcome. In the current inflationary environment, rising commodity prices could benefit exporters within EM, particularly South American countries, as the world’s industrialised economies rely on EM for commodities. Furthermore, Covid-19 has also become much less of a problem and the end of lockdowns will likely boost growth globally and reduce the imbalance in growth of the previous years.
The information in this document is given for information purposes only and does not qualify as investment advice. Opinions and assessments contained in this document may change and reflect the point of view of GAM in the current economic environment. No liability shall be accepted for the accuracy and completeness of the information. There is no guarantee that forecasts will be achieved. The mentioned financial instruments are provided for illustrative purposes only and shall not be considered as a direct offering, investment recommendation or investment advice. Assets and allocations are subject to change. Past performance is no indicator for the current or future development.