Opportunities From Higher Rates

With a challenging outlook for government bonds that have typically served as the foundation of the defensive allocation within portfolios, it’s increasingly important for investors to consider a range of non-traditional fixed income assets to hedge against inflation.

It is becoming increasingly evident that we have entered a structurally higher and more volatile interest rate environment. This is causing us to question the role that traditional diversifiers, such as government bonds, play in a portfolio going forward, while also encouraging us to explore non-traditional assets as differentiated sources of return and inflation hedges.

We identify three key forces contributing to a structurally higher inflation backdrop:

1. Growing geopolitical volatility will reverse previous efficiencies generated from globalisation via protectionist policies such as the reshoring of supply chains and more expansive tariffs to increase the competitiveness of domestic industries.
2. Ageing workforces and declining participation rates will add pressure to already tight labour markets, potentially driving up wages while also placing more strain on government fiscal positions given their need to spend on pensions and healthcare.
3. The transition to low-carbon technologies and renewable energy sources will involve significant upfront investments in new infrastructure while also diverting capital away from traditional energy sources which could contribute to higher energy costs and input prices.

US Budget Balance (As % of Gross Domestic Product)

Challenging backdrop for government bonds

A higher and more volatile inflation environment is generally seen as a more challenging backdrop for government bonds because it creates shorter and sharper interest rate cycles, while also increasing the opportunity cost of holding risk-free assets. This is a conundrum for asset allocators because government bonds have traditionally been viewed as a defensive staple; hedging against economic and geopolitical risks while providing a stable source of income.

One-way investors can counter this is by increasing their exposure to floating rate securities, where forward-looking returns move in tandem with interest rate or inflation expectations. Domestic floating rate credit exposures remain one of our highest conviction investment ideas in this space thanks to reasonable valuations, attractive all-in yields and strong underlying fundamentals (credit quality).

Fixed Income Yields

Yield-to-maturity, current vs. 2-years ago

Private credit exposures can also play a valuable role here, albeit investors should not underestimate the risks associated with the asset class. Huge sums of capital have been raised and deployed in recent years, creating more competition across lenders and subsequently resulting in tighter spreads and lower underwriting standards. Despite these concerns, we retain a positive outlook on the sector given our confidence in the resilience of the global economy which should mean that any ensuing credit cycle is relatively shallow with lenders adequately compensated via double digit yields.

Turning to hard assets

Another solution for investors is to increase exposure to ‘hard assets’ such as infrastructure, real estate and commodities where cash flows or asset values are, in one-way or another, positively correlated with inflation. We expect these assets to play a pivotal role in investment portfolios going forward as sources of both income and capital growth. The opportunity set in the infrastructure asset class looks particularly plentiful given the capital and investment requirements associated with the energy transition as well as the commitment from (and social pressure on) governments around the world to meet ambitious emission targets.