What is Schroders’ view on inflation – how long will the double-digit inflation persist and can investors outrun it?
To answer this question, allow me to briefly elaborate the macroeconomic perspective we come from and why inflation is indeed important for an economy.
As per economic definition, inflation is the price change of a specific product or basket over a 12 month period, and can only be expressed retrospectively.
To be clear, modest inflation is not a bad thing! You actually need a healthy inflation to run an economy, enabling companies to sell their products and services at higher prices, and to spend the additional profits on areas such as R&D, to upgrade for example the already existing product shelf. But in an overshooting inflationary environment, inflation gets a headwind since it squeezes households’ income and companies struggle to sell their products/services. Central banks now have to react with tighter monetary policy, which in turn can have further negative implications, i.e. for end consumers or refinancing purposes.
Most recently, inflation reached its highest level over the last 4 decades, and after years of support to cut rates and injecting trillions of dollars through QE, central banks globally were forced to shift their focus from growth to lowering inflation – even if this meant having to accept a recession. The reason behind this shift has been driven by a number of factors: first and foremost, the unprecedented lockdown and subsequent fiscal support from governments worldwide to revive societies, strong labour markets (particularly in the US), bottlenecks in global supply chains combined with China’s zero Covid policy and, last but not least, the war in Ukraine. But these were not the only reasons which spiked inflation, long-term structural trends such as demographics, deglobalisation and decarbonisation gave their finishing touches.
However, the good news for investors is that cash and fixed-income securities have since the beginning of this year resurged in value and you get rewarded again for the risk taken. So, from a diversification point of view, inflation has brought things back to normal.
But when we refer to inflation, it is important to clarify about which inflation we are talking about. In economic terms, there is an important differentiation between “headline” and “core” inflation. Headline inflation measures the total economic price increase of a specific basket of various wholesale products that households use daily, including food and energy. Core inflation excludes food and energy prices which can be very volatile. We’ve seen headline inflation moderating quite recently whereas core inflation continues to be very sticky and will remain elevated until labour markets loosen significantly. In the US, we expect CPI to ease from 8% in 2022 to 4.2% in 2023 and 2.3% in 2024, whereas in Europe higher food and services inflation has prompted upgrades to our HICP projections to average 5.6% in 2023 and 2.4% in 2024.
In a nutshell, double digit inflation numbers are not expected especially as we approach the end of this year, and inflation numbers for next year are expected to settle around 2-3% in advanced economies. Now, EU-countries such as Bulgaria, Hungary, Romania etc. which have their own currency will need to be more patient in seeing inflation coming down, since the own currency, national monetary policies and idiosyncratic market forces may hamper inflation rates to cool down with the same speed of larger EU economies. However, we have seen already some reaction of lower inflation in Bulgaria and are convinced that inflation rates will leave the double-digit territory quite soon.
Looking beyond 2024, inflation is here to stay and will remain quite volatile. Therefore, inflation needs to be taken (again) into consideration for investment decisions going forward. Moreover, the previously mentioned 3Ds (democratization, deglobalisation and decarbonisation) are unfolding a regime shift in markets which investors need to understand if they are to find the best opportunities and safeguard their portfolios. Therefore, investors have to weatherproof their portfolios and consider inflation in their investment decisions going forward for the short and long-run.
Is a global recession on the horizon? Which regions and sectors would be most affected and would there be any avoiding recession in 2023?
In anticipation of a so-called hard-landing, we’ve started this year with a more cautious tone allocating to more defensive, non-cyclical sectors such as consumer staples, utilities and health care. However, what we’ve seen so far is that investors have not been rewarded for being cautious nor for being offensive, and the highly expected recession (defined by two consecutive quarters of negative real GDP growth) is still holding off and inflation continues to be at elevated levels.
In Q4/2022, the majority of market participants assumed that the US economy would slide into a recession by mid-2023 latest, affecting other economies and countries. But the forecasted US & global recession have been pushed out, straddling – in our view – the end of this year and start of next. However, the real difficulty is that no recession can be accurately predicted nor whether a recession in one country may have negative implications on another country.
Germany for example has officially entered a recession, but has so far not provoked any serious downward spiral for other European countries. The opposite is true for the US – as the biggest economy in the world, a recession here can lead to serious challenges for other economies and countries. Moreover, since the USD is the world's leading currency, a recession in the US may have implication also on other currencies and asset classes, such as commodities.
Our research has shown that over the past 100 years for which we have been analysing recessions, US stocks have nearly always hit rock bottom during recessions, but have rebounded strongly towards the end of the period. The recovery in equities is driven by the combination of cheap equity valuations and expectations of future improvements in economic activity and corporate earnings thanks to policy easing by the Fed. By simply looking at the poor returns experienced during past recessions, investors should be mindful of missing out on the re-rating of the market.
With equities typically in the red during recessions, the more defensive sectors (defined by having a lower beta relative to the market) in the US, such as consumer staples real estate, utilities and health care, have on average delivered the strongest returns. This is because investors have looked for companies that offer superior profitability and robust balance sheets during times of economic stress. Instead, the more cyclical areas of the market (such as industrials, energy, financials, technology (tech), materials, consumer discretionary and communication services have tended to be the worst performers during a recession.
In a nutshell, there is no “one size fits all solution” to a recession as not all recession are equal and last for a predefined period, but also depend on specific idiosyncratic national factors. The traditional investment “cluster” during recessions is that investors escape to government bonds and to some extent corporate bonds as well as safe havens like USD.
For Bulgarian investors, what I can say, however, is to keep a cool head and a steady hand, diversify their portfolio across national borders and look for opportunities with reasonable entry levels.
What should investors prepare for, how would individual investors position their portfolios given the headwinds?
Our statistics show that we haven’t seen inflation fall from high levels without a fall in GDP around 2%-3%. Therefore, market participants should be prepared for a global GDP slowdown for 2023 as outlined in the first question.
In terms of portfolio allocation, I think the role of fixed income has changed for the better compared to the last few years, when investors invested solely, and sometimes forcedly, just for diversification reasons (as a reminder, about three years ago, up around 40% of global government bonds offered negative returns). The good news is that credit provides again attractive compensation along the fact that it has rarely been so cheap. Moreover, higher yield levels currently provide good protection for investors. It’s even possible to build a diversified portfolio with an average investment grade credit rating yielding close to 8%, and that’s a fund with daily liquidity. However, it’s still important to be selective and understand the difference between cyclical and structural impacts. Certain companies, such as in the telecom sector, have built a high level of leverage which was not perceived as a problem in a low rate environment. Telecoms are often seen as a defensive sector, but for some companies in this sector, this won’t be the case if they have to refinance that debt at, say, a 5% interest rate, compared to the much lower levels that prevailed in the past decade. That’s exactly a structural impact.
With regard to equity markets, we tend to be in a bear market environment, and probably about three-quarters of the way through it. Although some markets have de-rated, corporate earnings expectations have not yet dropped (the de-rating has happened because, with higher rates, companies’ future cash flows are worth less). But the prospect of recession isn’t yet fully factored into the market’s expectations for corporate earnings. In our view, forecasts for 2023 profits are too high. Earnings estimate have to come down quite a bit further before we reach the bottom of the market, so there is some space to go, but be careful: mind the gap!
In a nutshell, neither credit nor equities have been attractive options this year – cash has been the place to be and patience the key attribute to have. Even commodities have not provided an option lately even though inflation helps commodities.
So, how can investors position in this environment? When it comes to equities, we are moving from what we call a FOMO (fear of missing out) market to an environment in which fundamentals and valuations matter again. Also, quality is crucial in the current environment. Companies with good cashflows, solid business models and the ability to raise prices to offset inflation will fare best. It’ll be all about identifying those companies who can deliver earnings and avoid default. Meanwhile, bonds got more “juicy” again and they do have a role in the portfolio as a source of income. Allocations to IG credit along selected short-term sovereigns (we still have an inverted yield curve) could possibly make sense. Nevertheless, the current market conditions could be potentially a good entry point into commodities for those without exposure already. Commodities are interesting because in the last decade typically they weren’t a very useful allocation for the portfolio. In a more inflationary environment with greater geopolitical tension, commodities can replicate an important source of diversification.
Overall, vigilance and flexibility in the current environment are clear success components that will dictate positive or negative portfolio outcomes.
Based on your experience and observation in the CEE and Mediterranean countries you cover, can you outline differences and similarities between the behaviour and positioning of Bulgarian investors and the others in the region? In order to be helpful to our readers, many of whom are successful businessmen and executives in Bulgaria, could you share how is personal wealth invested in places like Greece, Hungary, Poland?
One of the nice things about my job is that I am responsible for a total of 7 countries in the CEE and Mediterranean region, and each country has its uniqueness, market structure & forces, market participants etc., so in general its own "colour". All colours combined result in a beautiful picture where here and there similarities and of course differences evolve.
During my career at Schroders, I’ve recognized that Bulgarian investors have developed with great strides and the market in general has become more mature. When I started in 2017, the expression “investment” was rarely used and in peoples’ mind profit maximization ideally in a very short period of time was the key priority.
In collaboration with our local partners we have helped investors to move away from short-term profit maximization to a long-term investment approach, providing them also access to global investment opportunities and, most importantly, balancing their BG-dominated portfolios.
The comparison to Hungary and Poland (also countries with own currency) is not that straight froward. The latter is the largest country geographically we cover in the CEEMED region. Polish investors are very much trimmed to Emerging Markets and Gold whereas Hungarian investors are skewed to sustainability. On the flipside of the coin, Greece is the European country which has suffered the most in the last decade. Companies had to recalibrate their business over and over again and individual investors had to escape from all forms of investment in Greece resulting in a "self-fulfilling and natural" diversification.
As you can see, all three countries have a different setup compared to Bulgaria, but what I think Bulgarian investors can copy & paste from these countries is a mixture of all: diversify your portfolio (like in Poland), increase your investment horizon and build resilient portfolios (like in Greece) and consider sustainability (like in Hungary).
Most Bulgarians place their money only in bank deposits and real estate. Now with the outlook for real estate souring, have people elsewhere in the region started to appreciate the benefits of having exposure to financial instruments like funds, stocks, bonds, commodities in their portfolios?
I have mentioned quite often the word diversification. The idea behind it is that investors can slice their risk and spread their income/profit streams. Practically, this means to broadly dispersing portfolio risk and increasing the probability of positive returns as they do not depend on one single income/profit source.
Holding a bank deposit is not wrong, especially now with higher rates, but my personal opinion is that behind every investment you need to understand the reason WHY you are doing this. Also, you have to understand what you want to achieve with your investment and what kind of risk profile you have. So, for example, if I want to offset inflation (i.e., maintain my purchasing power), a bank deposit will rarely help. With reference to Bulgaria, things are even more difficult: deposit rates are currently at 0% (and btw. since 2015!) while inflation rate hovering at 15%. This means that your 100 Lev today will only be worth 85 Lev in 12 months, and that’s exactly the loss of purchasing power. So, with a deposit that offers only 0 % return, you are not in a position to fight the value depreciation of your money. Ideally, BG consumers and investors need to find investments to earn 15% to be just flat, i.e. your 100 Lev will retain the same worth in 12 months. But even if you’ve achieved that, unfortunately you’ll not have enticed your money to "work" for you, i.e. your real rate of return is zero. If you want a positive number, you need a nominal return of more than 15%, and that is really hard to achieve without professional support (even 10-year BG government bond yields stand currently at 4,295% (as of 14.07).
However, since the question regarding deposits is one we deal with our clients on a daily basis, we wanted to find out how many years it would take to double your money if you only stay "invested" in deposits. Our results were astonishing: with a deposit rate of 0.25% (i.e. higher than the one in BG since 2015) it would take 276 years to double your initial lump sum amount, with 6.75% deposit around 9 years would be needed to reach this goal.
I totally understand that deposits are somewhat “risk-free” for banking clients and that they can sleep well at night. But my question is whether these people would sleep at night as comfortably if they realized that they’re silently losing the worth of their money day-in, day-out with just not outbalancing inflation and holding just a deposit account in their hands? But the good news is that there are plenty of opportunities how to achieve risk-aware returns and still sleep well at night – by the way, also through selective banking products. However, one way to do so, is to invest in mutual funds, which is basically a financial vehicle in which investment amounts from many investors are pooled to be invested in specific asset classes (such as equities, bonds etc.) by the fund manager.
Within the region I am covering, the number of depositors are (here and there) still quite high, but the difference is that most of these banking clients combine their deposits with investment exposure – in some countries with more bonds, in others with more equities. There is no holy grail, but the benefits of equities and bonds exposure are clear. In simple terms, equities provide the growth potential and bonds steady income. But the importance is to stay invested even during a turmoil in markets. Our research showed, that if you have invested €100.000 back on Jan. 1997 and forgot about your investment, you would have now around €450.093. If you have missed just the best 5 days in markets during the past 25 years (i.e. missed 1 out of 1250 days), your investment return would be around 33% lower, resulting in a total of €303.120. Take-away of this story: stay invested and never try to time the market. And that is exactly what many of my clients have understood and are enjoying the benefits of having exposure to financial instruments.
Now, the Real Estate sector has seen tremendous demand in the last decade, further elevated by ultra-low rates, of course. However, Real Estate plays and will play an important role in the next decades as this sector contributes around 40% of total global CO2 emissions (the vast majority of CO2 emissions result from energy consumption of existing buildings - their lighting, heating, and cooling). Hence, the good news is that Bulgarian investors are invested in a future-oriented sector which in turn needs to get drastically decarbonized by 2050. In my opinion, it will be important to seek exposure to enablers who will play a role in this transition, rather than solely investing in physical residences. This may prove very costly at some point in the future, as owners will be required by law to undertake EU-mandated sustainability retrofits.
One of the effective ways to invest in RE is through mutual funds for example. At Schroders, we have daily liquid products with global RE investment exposure, considering sustainability criteria and investing in a variety of RE, such as data & cloud centres, life science laboratories etc.
Overall, I would say that markets are getting more complex and the old regime of a 60/40 portfolio (60% Equities, 40% Bonds) is outdated. Investors need to take into consideration more factors when investing because we are moving from a two-dimensional investment perspective (risk & return) to a new era where we have to consider impact as well (third dimension). It is time for investors to understand that they can achieve much more with their invested money besides profit realization. It’s time to look beyond profit and invest with a positive impact to society and the environment.
The best way to implement this 3rd pillar into investment portfolios is through mutual funds and that’s exactly how clients within my region have started to appreciate these benefits as you can invest in bonds and/or equities including alternatives like commodities, real estate etc. but have nevertheless a positive foot print. This is confirmed by the tremendous interest in our impact strategies within my region.
With the rise of intertest rates there seems to be much higher demand for bonds and fixed income strategies. What can a global asset manager like Schroders offer in this segment, and what return can be expected by an investor with a 2-3 year horizon?
From the beginning of this year we have been saying that "bonds are back" and many investors have found their way back to bonds. We witnessed encouraging returns in fixed income since then and we expect this trend to persist as the year progresses. Last year’s headwinds are likely to become tailwinds this year as inflation has peaked, growth is slowing and the Federal Reserve (Fed) pauses or even reverses its tightening course. While we believe the absolute return potential across fixed income remains compelling, not all sectors are created equal. Our preference is tilted towards short-dated, higher quality and more defensive segments of the market, such as Treasuries and agency mortgages because they currently offer compelling valuations, income and liquidity characteristics. With the expectation of a slowing economy creating dislocations and disruptions, we view the liquidity that these assets offer as an additional benefit; liquidity enables investors to efficiently pivot to riskier segments of the market once the impact of tighter monetary policy is priced into securities.
At Schroders, we offer a broad range of fixed income products which can take advantage of the above mentioned situation and capture future market development. It is beyond the scope of this interview to describe the products we offer, but please feel free to contact our cooperation partners to give you the best possible advice.
However, considering the investment needs of Bulgarian investors (high income, low risk) we offer a global credit strategy with a pre-defined income target. SISF Global Credit Income is an unconstrained strategy that has the full flexibility to actively allocate to suitable opportunities within global credit (IG, HY, EMD, ABS/MBS, convertibles etc.) through a state of the art quantitative asset allocation process. The strategy has an average Investment Grade rating and comes with a fixed pay-out of 6.50% p.a. in USD terms and 4.50% p.a. in EUR terms. Furthermore, this fund is well suited for risk mitigation of the overall portfolio and serves as an all-weather bond solution for
A) investors in money market funds that seek higher income, but with limited drawdown risk
B) investors looking to diversify their local fixed income exposure or
C) investors in single bond issues/ issuer to diversify their concentration risk and mitigate the default risk
As this is an unconstrained strategy, we do not run the fund with a pre-defined target. For this purpose, we offer strategies like SISF EURO Corporate Bond or SISF Strategic Credit.