Many investors have become increasingly concerned about the likelihood of interest rates rising in the future, perhaps accompanied by bouts of inflation.
Instead of trying to read the monetary tea leaves, we believe active investors may be well served to focus on what they can control: picking securities and controlling portfolio risk. We also believe that interest rate and inflation preparedness goes beyond traditional bond asset classes, expanding to include traditional growth and value-oriented equities, listed infrastructure, and listed real estate. In the sections that follow, portfolio managers from each of these areas share brief thoughts — at the portfolio level — about accommodating inflation and rising rates.
By Kevin Brown
While past performance does not guarantee future results, the companies we hold in the portfolios we manage have certain characteristics that have historically performed well in a rising-rate or higher-rate environment.
We tend to avoid companies that have heavy capital expenditure funding needs or that maintain high degrees of leverage, for example. Flexibility in a company’s capital allocation structure could be a powerful aspect during a higher-inflation environment, and that is one of the characteristics that we look for in a business. It is also important to note that we currently have a little more exposure to commodity and hard-asset plays than normal, and those positions could provide our portfolios with a potential hedge if inflation were to increase.
In addition, the ability to pass along pricing to customers can be a key advantage for companies in an inflationary environment. We believe that the companies in our portfolios have competitive positions and therefore may be able to pass along pricing changes better than their competitors. In our opinion, charging higher prices while keeping costs constant (or taking advantage of flexible cost structures) enables companies the potential to grow profitability even faster than revenues.
By Ty Nutt
We believe we’re nicely positioned if inflation revives or interest rates finally rise because we maintain a sizable allocation to energy companies and are underweight in financials and utilities.
Of course, much will depend on the details. If inflation increases quickly and by a lot, all sectors could be affected and potentially hurt quite badly (the chart below takes a look at this relationship). But if a normalization of rates happens gradually, we believe the market could come through fine, notwithstanding some valuation compression and sentiment deterioration.
Even within those sectors that overall might be hurt by elevated inflationary pressures or rising interest rates — financials, for example — there could be pockets of strength. Banks could actually benefit from a higher rate structure because it would potentially improve their net interest margins, which have suffered as of late. Insurance companies also could gain because they could finally squeeze some yield out of their fixed income portfolios. The main casualties of higher rates and inflation would potentially be in the utility and consumer discretionary spaces, which are areas in which we currently maintain significantly underweight positions.
|Top sectors as of 03/31/2013
List excludes cash and cash equivalents.
||% of portfolio
(Data: U.S. Department of Commerce, Federal Reserve, accessed in April 2013.)
Chart above is for illustrative purposes only and are not representative of the performance of any specific investment.
Indices are unmanaged and one cannot invest directly in an index.
The S&P 500 Index measures the performance of 500 mostly large-cap stocks weighted by market value, and is often used to represent performance of the U.S. stock market.
By Brad Frishberg
Inflation protection is one of the key aspects that we believe makes global infrastructure attractive as an asset class. About half of the portfolios we manage have some form of inflation protection, and often times this protection is direct and formulaic.
For example, one of our current holdings, an international toll-road developer with major assets in Australia, has more than 20 years remaining on its concession: we believe it will likely raise tolls automatically every year to reflect the inflation rate. (For a look at how this relationship has played out in the past decade, see the chart below.)
(Source: Transurban Group, as of May 2013.)
Regulated assets, another type of listed infrastructure, can also have inflation hedges built into its contracts. Regulated assets include businesses involved in electricity and gas transmission and distribution (that is, the poles and wires, or suburban gas pipelines) that deliver electricity and gas to households, and water companies that provide fresh water and remove waste water.
In determining the price that may be charged to customers, the regulator typically ensures that the regulated company is able to earn a return in excess of its cost of capital, including permitting the regulated company to raise its tariffs in future years by a level linked to the inflation rate. Thus, regulated entities are able to generate revenue streams that have the potential to grow at least in line with inflation. In our opinion, these kinds of contractual, inflation-linked revenue bases may provide infrastructure investments (including many of those within our portfolios), with a direct inflation hedge.
By Bob Zenouzi
We believe current Federal Reserve policies are forcing some investors to: 1) invest in hard assets (that is, real estate) that may endure during the eventual inflationary result of current policies, and 2) buy financial assets that provide what the Fed policies are taking away (that is, yield). As a result, today’s loose global monetary policies seem to be a potential win-win for the real estate sector, even if the monetary policies that drive it are misguided, in our opinion.
Historically, real estate investment trusts (REITs) have been hedges against inflation, and we believe that this pattern may continue if inflationary pressures begin to increase. In today’s environment, for example, approximately 85% of the debt of U.S. real estate companies is fixed; this figure is higher than was the case during the last cycle (data: Citigroup). It also bodes well, in our opinion, for the real estate sector, since borrowing costs are going to rise along with interest rates at some point down the road. In addition, many commercial tenants are locked into six- and seven-year leases, with rent step-ups over the life of the lease that are tied to inflation.
We still have to choose the right companies, but overall we believe that real estate has the potential to perform quite well in either a rising rate or an inflationary environment.
No one has a perfect view of the macroeconomic developments that lie ahead. There are many factors to account for, and the links between them can be difficult to spot. Nevertheless, both equity and fixed income portfolio managers at Delaware Investments are keeping inflation and rising rates in mind as they assess the bigger picture and analyze the preparedness of the portfolios they oversee.
As noted in their comments, the implications of rising rates and inflation may not be the same across all sectors and industries. But each of their portfolios contains some facet — whether it’s a sector position or a specific industry concentration — that can potentially aid performance in the midst of an inflationary upturn.
Investing involves risk, including the possible loss of principal.
International investments entail risks not ordinarily associated with U.S. investments including fluctuation in currency values, differences in accounting principles, or economic or political instability in other nations.
Investing in emerging markets can be riskier than investing in established foreign markets due to increased volatility and lower trading volume.
Narrowly focused investments may exhibit higher volatility than investments in multiple industry sectors.
Because the Fund concentrates its investments in securities issued by companies principally engaged in the infrastructure industry, the Fund has greater exposure to the potential adverse economic, regulatory, political, and other changes affecting such entities.
REIT investments are subject to many of the risks associated with direct real estate ownership, including changes in economic conditions, credit risk, and interest rate fluctuations. A REIT fund’s tax status as a regulated investment company could be jeopardized if it holds real estate directly, as a result of defaults, or receives rental income from real estate holdings.
"Nondiversified" Funds may allocate more of their net assets to investments in single securities than "diversified" Funds. Resulting adverse effects may subject these Funds to greater risks and volatility.