 [3 min read, open as pdf]
Through the looking glass: a curiouser new paradigm Traditionally you bought bonds for income, and equity for risk. Ironically, now it’s the other way round. The past decade or more has been a challenging period for income investors. Global quantitative easing programmes were launched in response to the global financial crisis of 2008. Further stimulus was prompted as part of the fight against the effects of the COVID pandemic. These policy interventions have suppressed yields for over a decade. Furthermore, inflation is now surging and is likely to settle at higher levels than pre-Covid. This further undermines the ability of bonds to generate a real income. The prospect of rising rates limits the appeal of longer-dated higher yielding bonds owing to the higher duration risk (the decline in a bond’s value, linked to rises in interest rates). In the last two years, we have had an extensive period of disruption and change: the pandemic lock-downs, the policy response (stimulus), the economic restart, supply chain disruption, energy crisis, inflation break-out and interest rate cycle “lift off”. As a result, we are living in a “curiouser new paradigm” of:
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2021 in review Our 2021 market roundup summarises another strong year for markets in almost all asset classes except for Bonds which remain under pressure as interest rates are expected to rise and inflation ticks up. Listed private equity (shares in private equity managers) performed best at +43.08%yy in GBP terms. US was the best performing region at +30.06%. Real asset exposures, such as Water, Commodities and Timber continued to rally in face of rising inflation risk, returning +32.81%, +28.22% and +17.66% respectively. 2022 outlook We are continuing in this “curiouser, through-the-looking glass” world. Traditionally you bought bonds for income, and equity for risk. Now it’s the other way round. Only equities provide income yields that have the potential to keep ahead of inflation. Bonds carry increasing risk of loss in real terms as inflation and interest rates rise. Real yields, which are bond yields less the inflation rate, are negative making traditional Bonds which aren’t linked to inflation highly unattractive. Bonds that are linked to inflation are highly sensitive to rising interest rates (called duration risk), so are not attractive either. How to navigate markets in this context? The big three themes for the year ahead are, in our view:
See full report in pdf Attend our 2022 Outlook webinar  [3 min read, open as pdf]
UK cost of living surges Pent up demand, disrupted supply chains and an energy crisis are hitting UK consumers hard. This is becoming a problem that is as political as it is economic. A deeper look and understanding of inflation within different segments of the CPI basket is informative. Get the full article as pdf Watch our Focus on Inflation CISI-accredited CPD webinar  [3 min read, open pdf for full report with charts]
Inflation on the rise With inflation on the rise – and potentially interest rates too – nominal bonds are likely to remain under pressure. Whilst “real assets” – such as property, infrastructure and gold – have potential to preserve value in inflationary regimes, how can a switch from bonds to real assets be made without materially up-risking portfolios? This was the challenge we addressed in the design of our Liquid Real Assets index. Our Liquid Real Assets Index was developed to combine exposure to higher risk-return real asset exposures, with lower risk-return interest rate-sensitive assets, to deliver a real asset return exposure for inflation protection, in liquid format, with bond-like volatility to keep risk budgets in check. Given the rising inflationary pressures both in the US and in the UK, we take stock on the index performance year-to-date and are glad to say it’s “doing what it says on the tin. Find out more about the Elston Liquid Real Assets Index Watch the introductory webinar View the year-end index factsheet  [3 min read, open as pdf]
Sustained recovery in risk assets 2021 saw a sustained recovery in risk assets, with the exception of Emerging Markets. Listed Private Equity was the top performing exposure returning +43.08% in GBP terms. Regionally, US equities remained the strongest performing market +30.06%. Real assets to the fore Real asset exposures, such as Water, Commodities and Timber continued to rally in face of rising inflation risk, returning +32.81%, +28.22% and +17.66% respectively. Our Liquid Real Assets Index (ticker ELSLRA Index) – which combines higher risk real assets and lower risk rate-sensitive assets to deliver volatility similar to bonds – returned +7.98%, whilst UK Gilts declined -5.16%. UK equity income strength Within UK equity market segments, UK Equity Income outperformed all other segments as inflation fears made income-generative, value-oriented shares relatively more attractive. UK Equity Income, represented by our Freedom Smart Beta UK Dividend Index (ticker ELSUKI Index), returned +20.77%, whilst UK Large Cap returned +19.68% and UK Core returned +18.44%. UK Small Cap was the weakest UK segment, returning +14.70% for the year. Read as pdf Register for our Quarterly Investment Outlook on 26 January 2022  [7 min read, open as pdf]
Fed signals tightening Fed Chairman Jerome Powell signalled that inflation is now the biggest risk to growth, and getting the labour market back to pre-pandemic levels. The US will accelerate “tapering” or reduction of supportive asset purchases, and set out the potential for rate hikes in coming years (although no change in long-term target rate). And despite rate hikes usually spooking markets, markets rallied: why? Because the bigger concern was that the Fed was behind the curve and not getting on top of inflation. The risk of a so-called “policy error” had investors concerned. The fact that market-implied policy rates did not change before and after the policy announcement, suggests that this was a case of the Fed catching up with the market, than the market catching up with the Fed. UK inflation Meanwhile, UK inflation pressure continues, with November inflation data coming in at +5.1%yy, ahead of +4.8%yy forecast, the fastest rate in a decade. Transport, clothing and food were the main contributors. The risk is that inflation creeps into wage growth which would make it harder to bring inflation down to long-term target of 2.0%. This is the second month in a row of an upside surprise. The figure is also at the upper end of scenarios envisaged by the Bank of England at the November MPC meeting. Bank of England raises rates The Bank of England today announced a +0.15% increase in the Bank Rate from 0.10% to 0.25% citing “more persistent” inflation, and following the Fed’s lead in a greater level of tightening. Furthermore, the Bank of England minutes suggest that inflation could remain at elevated levels and “expect inflation to remain around 5% through the majority of the winter period, and to peak at around 6% in April 2022” Markets are pricing a 80% chance of a further +0.25% to 0.50% in February 2022. In October, BoE Governor, Andrew Bailey guided that rates would need to rise to address inflation. Where are breakeven rates? The UK 5 year breakeven rate is at 4.38%, following the announcement, compared to 4.66% at the end of last week. The US 5 year breakeven rate is at 2.73% today from 2.80% at the end of last week. Liquid Real Assets performance Our Liquid Real Assets Index combines exposure to higher risk-return real assets for inflation protection and lower risk-return rate-sensitive assets for interest rate hike protection for an overall volatility that is comparable to UK bonds. By incorporating allocations to exposures that are driving inflation, such as Commodities, or can pass-through inflation, such as Property and Infrastructure, the real assets index can provide a return premium in excess of inflation and in excess of nominal bonds. Summary Inflation is proving persistent, policy makers are catching up to keep it in check. Nominal bonds will remain under pressure, particularly longer-duration in a rising inflation, rising interest rate environment. We advocate pairing equity allocations with diversified real asset exposure that can respond to inflation and floating rate notes that can respond to interest rate hikes. Read full article with charts as pdf Register for our Quarterly Investment Outlook on 26 January 2022  US CPI November data came in line with expectations at +6.8%yy vs +6.2%yy in October, meaning there is no additional pressure on expected interest rate rises for 2022.
 [5 min read, Open full article as pdf]
Triple whammy of external factors saw market risk spike The emergence of the Omicron COVID variant spooked markets last Friday as a growth scare, with a knock-on effect of increased supply chain disruption and inflationary pressure. But as material were the Fed Chair, Jerome Powell’s statements on bringing forward tapering, partially in (some might say, belated) response to inflation risk. Open full article as pdf Register for our Quarterly Investment Outlook on 26 January 2022  [5 min read, open as pdf]
Interest rates expected to rise As the run up in inflation looks more persistent, than transitory, there is growing likelihood that Central Banks will raise interest rates in response. Following an extended “lower for longer” near-Zero Interest Rate Policy following the 2008 Global Financial Crisis and the 2020 COVID Crisis, the market futures-implied expectations for the Fed Funds rate, points to a “take off” in 2022 in response to rising inflation, following COVID-related policy support, to an expected 1.01% interest rate level in Dec-23[1], from 0.88% last quarter. Fig.1. Fed Funds Rate and implied expectations  Source: Elston research, Bloomberg data
The potential for increased interest rate volatility, as rate hike expectations increase, means that investors that are seeking to dampen interest rate sensitivity (“duration”) are allocating to shorter-duration exposures, such as ultrashort-duration bonds, and also to Floating Rate Notes (FRNs). What is a Floating Rate Note? Floating Rate Notes receive interest payments that are directly linked to changes in near-term interest rates and can therefore provide a degree of protection against interest rate risk, when interest rates are rising. Issued for the most part by corporations, FRNs pay a periodic coupon – typically quarterly – that resets periodically in line with short-term interest rates. This could be expressed as a premium or “spread” over a currency’s short-term risk-free rate, such as (in the UK) the 3 month SONIA rate (Sterling Overnight Index Average, and prior to that GBP LIBOR) in the UK, or (in the US) the 3 month SOFR (Secured Overnight Funding Rate, and prior to that USD LIBOR). These indices overnight borrowing rates between financial institutions. The size of the premium or spread reflects the creditworthiness of the issuer: the higher the spread, the greater the rewarded risk for owning that security, and typically stays the same for the life of the bond and is based on the issuer’s credit risk as deemed by the market. How can FRNs benefit investors? Floating Rate Notes are a lower-risk way of putting cash to work and provide a useful direct hedge against interest rate fluctuations. When incorporated into a bond portfolio, they can help bring down duration given their reduced sensitivity to interest rate changes, as well as provide a return pattern that is directly and positively correlated with changes in interest rates. Compared to nominal bonds, such as Corporate Bonds and UK Gilts, FRNs’ yield can increase as/when interest rates increase. Relative to money market funds, FRNs may provide some additional yield pick-up, as well as very short <1 year duration. Key considerations when investing in FRNs Portfolio investors can access FRNs through funds and ETFs. Key considerations when investing in FRNs include, but are not limited to:
Summary The expected timing of interest rate “lift off” in the US and UK will change as markets adapt to evolving growth and inflation outlook during the post-COVID recovery, and in response to the risk of further disruption from new virus variants. However, as interest rate rises become more likely, and incorporating an allocation to Floating Rate Notes for protection against interest rate risk makes sense within the bond allocation. Watch the CPD Webinar: The Quest for Yield [1] Data as at last quarter end 
Inflation on the rise With inflation on the rise – and potentially interest rates too – nominal bonds are likely to remain under pressure. Whilst “real assets” – such as property, infrastructure and gold – have potential to preserve value in inflationary regimes, how can a switch from bonds to real assets be made without materially up-risking portfolios? This was the challenge we addressed in the design of our Liquid Real Assets index. Our Liquid Real Assets Index was developed to combine exposure to higher risk-return real asset exposures, with lower risk-return interest rate-sensitive assets, to deliver a real asset return exposure for inflation protection, in liquid format, with bond-like volatility to keep risk budgets in check. Given the rising inflationary pressures both in the US (where in Oct-21 it crossed 6%, the highest level in 30 years) and in the UK (where in Oct-21 it crossed 4%, the highest level in a decade), we take stock on the index performance year-to-date and are glad to say it’s “doing what it says on the tin. [Read full article] [Watch the webinar]  [3 min read, open as pdf]
Ahead of estimates UK CPI print for October came in at 4.2%yy vs 3.9% estimate and 3.1%yy in September. Inflation rates were higher than expected and the highest in a decade, putting more pressure on the Bank of England to raise interest rates and creating a palpable squeeze on cost of living for households through the winter. The increase was driven by energy prices and the impact of supply shortages across the economy. 
Inflation is proving more persistent than transitory. In an inflationary environment, Value style investing has the potential for continued outperformance relative to other factors. For UK fund investors, actively managed funds with a value-oriented philosophy, UK equity income funds with an inherent value bias and Value-factor index funds/ETFs offer ways of increasing allocation to Value within a portfolio. Read the article (5 min read) Watch the webinar 
Ahead of estimates, again US CPI print for October came in at 6.2%yy vs 5.9% estimate and 5.4%yy in September. Higher prices for energy, accommodation, food and vehicles drove the October print and suggested that inflation pressure is broadening out beyond just the “reopening” sectors. Get the full report Visit our Liquid Real Assets page  Register for the webinar/View the replay Read the full article
What is the 60/40 portfolio? Trying to find the very first mention of a 60/40 portfolio is a challenge, but it links back to Markowitz Modern Portfolio Theory and was for many years seen as close to the optimal allocation between [US] equities and [US] bonds. Harry Markowitz himself when considering a “heuristic” rule of thumb talked of a 50/50 portfolio. But the notional 60/40 equity/bond portfolio has been a long-standing proxy for a balanced mandate, combining higher-risk-return growth assets with lower-risk-return income-generating assets. What’s in a 60/40? Obviously the nature of the equity and the nature of the bonds depend on the investor. US investors look at 60% US equities/40% US treasuries. Global investors might look at 60% Global Equities/40% Global Bonds. For UK investors – and our Elston 60/40 GBP Index – we look at 60% predominantly Global Equities and 40% predominantly UK bonds Why does it matter? In the same way as a Global Equities index is a useful benchmark for a “do-nothing” stock picker, the 60/40 portfolio is a useful benchmark for a “do-nothing” multi-asset investor. Multi-asset investors, with all their detailed decision making around asset allocation, risk management, hedging overlays and implementation options either do better than, or worse than this straightforward “do-nothing” approach of a regularly rebalanced 60/40 portfolio. Indeed – its simplicity is part of its appeal that enables investors to access a simple multi-asset strategy at low cost. The problem with bonds (the ‘40’) in an inflationary environment Over the years, the relationship between asset classes has changed so much that the validity of 60/40 as a strategy can legitimately be questioned. Read the full article or register for the webinar/View the replay 
The era of quantitative easing programmes have had a distorting effect on markets since the 2008 financial crisis has given value investors a torrid time in the past decade. The near-constant sugar-rush of liquidity has served to de-link valuations from underlying fundamentals prompting a huge bias towards growth. While pockets of investors have been braced for a long-expected correction that has never really materialised, the recent sharp increase in inflation may constitute an inflection point of sorts. In inflationary periods and when interest rates rise, the time horizon for future discounting shrinks, leaving equities exposed. Income-yielding shares have an inherent value-bias, owing to the types of company that pay steady dependable dividend). This provides a measure of inflation protection both in absolute terms and relative to nominal bonds. Read the full article Watch the webinar  [3 minute read]
Request the research paper Register for our CISI-accredited webinar with guest speakers from the World Gold Council Throughout recorded history, gold – rare and unreactive – has held its place as a coveted precious metal. Useful as both a store of value and as a means of exchange, in the modern era, gold has a core part to play in investor portfolios. Exposure to it offers investors three key benefits: insurance against shocks, risk-based diversification and – most significantly in our current environment - a hedge against inflation. The only free lunch in financial markets? The diversification effect is not only about adding an additional asset class, it is about an uncorrelated return pattern relative to both equities and bonds. Of all the precious metals and broader commodities traded, gold holds its own as the most powerful diversifier, exhibiting consistently low correlation with other major asset classes. Resistance to volatility Not only does gold outperform other commodities over time but it has also tended to perform positively when volatility increases. In periods of high inflation and currency devaluation, gold serves to protect investors’ purchasing power. Gold’s insurance characteristics mean that the optimal allocation for gold increases when risk in a portfolio increases. Current relevance In the ultra-low interest rate environment of today, increasing inflation fears means negative real yields, therefore the opportunity cost of holding non-income-generating assets is declining. While commodities provide near-term inflation protection particularly when related to supply shocks, gold has typically provided greater inflation protection characteristics during inflationary regimes, in part because the gold price reflects broader economic growth as defined by consumer price inflation and money supply. Not the only precious metal diversifier Gold is by no means alone in the precious metals category. Other key metals in the asset class include silver, platinum and palladium, each with characteristics of their own. All three carry significant value as industrial metals required in manufacturing of batteries, super-conductors and within the auto industry, rendering their prices more vulnerable to supply and demand fluctuations, and thus increased volatility. We explore the value they can offer and the role they can play within a portfolio. How to gain access as a retail investor? While professional investors can gain access to gold via the Futures market, what are the options available to UK advisers when constructing a retail client portfolio? From precious metal ETPs to funds of producers to simply buying and storing a bar of gold, we delve into the pros and cons, offering an unbiased overview of the opportunities available.  [Open full article as pdf]
“Suppose we define a passive investor as anyone whose portfolio of U.S. equities is the cap-weight market portfolio described above. Likewise, define an active investor as anyone whose portfolio of U.S. equities is the not the cap-weight market portfolio. It is nevertheless true that the aggregate portfolio of active investors (with each investor's portfolio weighted by that investor's share of the total value of the U.S. equities held by active investors) has to be the market portfolio. Since the aggregate portfolio of all investors (active plus passive) is the market portfolio and the aggregate for all passive investors is the market portfolio, the aggregate for all active investors must be the market portfolio. All this is obvious. It is just the arithmetic of the fact that all U.S. equities are always held by investors. Its implications, however, are often overlooked.” What Bill Sharpe was saying to us was this: the performance of all active managers is, in aggregate [for a given asset class] that of the index less active fees. Which is a considerably worse deal than the charge often levelled against passive funds, namely that investors are paying for the performance of the index less passive fees. CPD Webinar: Is active management a zero-sum game?  The rapid restart, supply chain disruption and scramble for gas is creating an inflationary Big Squeeze... whatever next and how to adapt? Whilst we would like to think inflation will be transitory rather than persistent, events are making that thinking look wishful. Our market update webinar will take stock of what's happening and why, and how to position portfolios from an asset allocation perspective.
To join the discussion on macro and market outlook, we are delighted to welcome Karim Chedid, CAIA, Director and Head of Investment Strategy for iShares EMEA. Agenda 1. What's driving "The Big Squeeze" - rapid restart, pent-up demand and supply shortfalls: how does this play out? 2. We assess the outlook against the "triangle" of growth, inflation and interest rates 3. We look at market regime, and portfolio resilience and vulnerabilities in an inflationary world Please join us on Wed 27 Oct at 1030am 
Read the article in full (5 min read) Following the post-COVID restart, there would necessarily be an inflationary spike, from base effects alone. Central Banks’ core thesis was that this spike would be “transitory”, rather than “persistent”. However, the combination of pent-up demand, supply chain disruptions and an energy crisis suggests that inflation could prove more persistent than transitory. We look at the numbers and how this informs the “big picture triangle” of three key macro factors: growth, inflation and interest rates. Finally, we outlined potential interventions in portfolio positioning from an asset allocation perspective. Nominal bonds are known to be structurally challenged in an inflationary regime, and propose real asset exposure instead. Within equities, we would propose an income/value bias. Regiser for our 3q21 Review & Outlook: The Big Squeeze  Money market funds, and their exchange-traded equivalents “ultra-short duration bond funds”[1], are an important, if unglamorous, tool in portfolio manager’s toolkit. They can be used in place of a cash holding for additional yield, without compromising on risk, liquidity or cost. Money market funds are intended to preserve capital and provide returns similar to those available on the wholesale money markets (e.g. the SONIA rate that replace LIBOR). How risky is a money market fund? Money market-type funds hold near-to maturity investment grade paper. Their weighted average term to maturity is <1 year. They therefore have very low effective duration (the sensitivity to changes in interest rates). Compare gilts which are seen as a low-risk asset relative to equities. The 10-11 year duration on UK gilts (all maturities) means they carry a higher level volatility compared to cash (which has nil volatility). On the flip side, their longer term also means they have higher risk-return potential relative to cash and ultra-short bonds. By contrast, money market type funds have some investment risk as they hold non-cash assets, but given their holdings’ investment grade status, short term to maturity and ultra-short effective duration, they exhibit near-nil volatility. Platform cash, fixed term deposit or money market fund From a flexibility perspective and a value for money perspective, there's a clear rationale to hold money market funds, rather than platform cash or a fixed term deposit. Our Money Markets fund research paper that looks at 4 low cost money market funds sets out why Why does the fund structure make sense? Find out more in our CPD Webinar on Introduction to Collective Investment Schemes |
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