Global bond markets have been rattled by rising inflation, which has continued to breach decade-level highs in the UK, Europe and the US and although the market consensus is that inflation will eventually settle down from this high base, Baillie Gifford Multi Asset Income fund co-manager Steven Hay has warned that fixed income investors could still be in a pickle.
He said that if figures remain higher than the pre-pandemic level, fixed income investors’ income will fail to keep up with inflation in real terms.
Hay singled out central banks as one of the major drivers of higher inflation today. “I think they threw a whole lot of stimulus at the economy when they didn't need to,” he said. “Both the supply side and the demand side contracted at the same time – they didn't need to throw so much stimulus at it.
“It just created this momentum on the demand side and then it seems now we have had sequential supply shocks.
“My view was that there had been a multi-decade period of inflation falling and I think the global conditions that allowed that to happen are slowly reversing.”
Prior to becoming a fund manager, Hay worked at the Bank of England’s Monetary Policy Committee (MPC) for seven years.
Although he said economies have already passed the high watermark in terms of nominal inflation figures, it is his expectation that inflation will be higher than it has been in the past.
“I think we'll come back down from here,” he said. “We're close to the peak probably without another supply shock happening. I think as it comes down, we need to look at it carefully and see what's happening to wages and what's happening to the run rate of core inflation.
“My guess is it's going to stay higher because people are going to want to catch up on the loss of real income from wages and bargain for higher – so we expect inflation to stay a bit higher.”
As a result, he warned that markets are entering a “tricky” investment environment and that stagflation – rising unemployment and slowing economic growth coupled with rising inflation – is not off the table.
“What you don’t want be is in portfolios full of fixed income, then you really are stuffed,” Hay said. “That’s why we’re making sure we’re not putting too much in fixed and we’re hedging.”
Indeed, the Baillie Gifford Multi Asset Income fund has just 2.2% allocated to investment grade bonds versus 11.4% allocated to high yield bonds.
High yield bonds have held up better than investment grade bonds year-to-date, buoyed by higher coupon payments amidst a broader write-down in global bond values.
Performance of IA Global High Yield Bond sector vs IA Global Corporate Bond sector
Source: FE Analytics
“High yield within fixed income is quite a good place to be,” Hay said. “We favour the resilient end of the high yield spectrum. With high yield companies, a bit of inflation is not too bad for them provided they have pricing power – it helps to erode the value of their debt.”
The team also take the view that emerging market debt is better positioned amidst rising inflation in the developed world.
As such, the fund has 14.2% invested in emerging market bonds versus just 0.3% invested in developed government bonds.
Hay said that the bond team has “cherry picked” the best emerging market bonds they can find to mitigate against inflation.
“In Brazil, Colombia and Uruguay, we have inflation linked bonds: there you get a positive real yield and the protection against inflation,” he explained.
Outside of fixed income, the fund’s largest exposure is to global equities, where 34.1% of the portfolio is invested.
Although inflation hurts consumer spending, it also hits the profitability of companies – this is a major a risk for equity investors.
Global equities have also experienced a bit of a tumble as investors brace for higher inflationary costs weighing down on earnings.
MSCI World Index year-to-date
Source: FE Analytics
Addressing this risk, Hay said: “James Dow, who manages the equity part of the portfolio, is trying to pick companies that are growing and are in areas of demand with pricing power – if you've got pricing power then you should be able to protect the margins.
“If you have a portfolio that simply has high yield bonds, you will see your income drop steadily in real terms over time.”
Hay’s central view on inflation is that the demographic trends which enabled low inflation are now reversing and that economies are de-globalising – an opinion echoed by BlackRock’s Larry Fink last month.
Although he has many colleagues within Baillie Gifford who argue that the rapid advancement of technologies will bring inflation down, Hay said the impact of these technologies on inflation is “overestimated”.
He noted: “There are a lot of things that might stop you raising rates and slowing the economy down that you would want to do if you were an independent central bank.
“I just don't believe they [central banks] are independent anymore. I think it is the level of debt we have as an economy, it's funding the green transition, funding defence spending – I think it's very hard for the central bank to say: ‘you guys are spending far too much, we're going jack up interest rates and slow the economy down’.
“Inflation is probably going to stay a bit stickier and central banks will find it hard to do what they’ve found it easy to do in the last few decades.”